Getting started in option trading
My past couple posts have been on option trading and Stock Trading System, so I thought I would just follow up with a series of posts regarding getting started in option trading .
Many retail traders only experience with options is buying a call or put on a stock they think will move because they wanted a cheaper way to play a stock move. The problem with that strategy is most people have no clue about how an option’s price is determined.
For example : What is the extrinsic value for the option ? Where is Implied Volatility for the option ? Is there large positive/negative skew between the front/back months for that stock option you are looking at ? What is the delta of the option you are buying ?
I will be covering the answers to some of the above questions in future posts but for this post lets keep it simple and make sure you understand the basics of options.
What is an Option
An option is essentially a contract that allows you the right to buy 100 shares of the underlying security at a certain price(“strike price”) by a certain date(“expiration date”).
Realize that as an option buyer it just gives you the right to exercise the option contract but you are under no commitment to do so.
Most people though don’t usually exercise an in the money option but rather just close out the option by buying an offsetting position and collecting the profit on the option premium prior to expiration so they don’t end up with a 100 shares of the stock.
A call option benefits when the underlying stock price moves up because it allows you to “call” the stock to you at a specific price, so if xyz stock is $50 and you have a call option with a strike price of $45 then you can exercise the call option getting the stock at $45 and sell it in the open market at $50 for a hypothetical profit of $5 (minus premium costs of the call option).
Put options are the opposite of call options in that you benefit owning a put option when the stock price goes down as it allows you to “put” the stock to the put option seller at a high price that the market price, so if the stock is currently $45 and you own a put option with a $50 strike price then you have the right to exercise the put option and sell the stock for $50 even though the stock is only $45 (thereby making $5 per share profit minus cost of put option.
Once you understand the basic of an option then it is time to move onto understanding the components that are used to determine and options price, also known as “The Greeks”. I will cover the “The Greeks” in future posts.
Without a proper understanding of option pricing then you could end up being right on the direction of the stock but end up having your option expire worthless or only see a small benefit from the price move.
If you want to develop a solid foundation and method for making an income with options then I would highly recommend Trading Pro System (See my past posts 1 & 2 on Trading Pro System). It is well worth the money.
Disclaimer: To understand the risks in option trading, you can read this pamphlet (It is the standard options investing industry brochure you get when opening an options account)