SUCCESS CONCEPTS FOR TRADING STOCK OPTIONS
by Billy Williams
Stock options are a misunderstood investment tool but once understood by both traders and investors it can be a very versatile investment tool. However, as a consequence of their versatility, options are often viewed as to complex for the beginning option trader to utilize effectively. In order to avoid common mistakes of the beginning traders or investors it's important to understand a few basic concepts like types of options offered, leverage, risk control, time, and strike prices.
It is vital that you understand that there are two types of options that are commonly available on exchange traded companies are called "calls" and "puts". Calls are purchased when an option investor believes that the underlying instrument, or stock price in this case, is about to rally and go higher. Put options, however, are purchased when a particular option investor believes that the share price on the company is about to fall and go lower. Once you understand the directional bias of each option alternative you understand more effectively your available choice when speculating on the direction of the stock you are analyzing.
The second factor to understanding stock options is that they offer one of highest sources of leverage by allowing you to control blocks of 100 shares per each option. For example, if you bought 100 shares of a $60 stock then you would have $6,000 invested but you would only need a few hundred dollars to control the same position with options. If your $6,000 worth of stock rose from a share price of $60 to $72 and you sold then you would realize a gain of 20% or $1,200. But if you owned call options on the same position you could conceivable earn a 200% or 300% gain!
You should now begin to feel your eyes opening to the raw potential that options offer the investor with this kind of leverage but you really start to see there potential when you understand how options control your risk in even the worse circumstances. If you had invested in 100 shares of ABC company's stock at $70 a share then you would have $7,000 tied up in that position. Now, let's just project that the CEO of ABC announces that the company is filing for bankruptcy and as result the company's stock falls to zero. You have just lost your entire investment of $7,000! However, if you had used call options your cash outlay would have just been a few hundred dollars to control the profit potential of the same 100 shares. Whereas you lost everything by buying the ABC's stock you would only have lost a few hundred dollars with just owning the call option. By understanding just how important it is for you to limit your risk to the market or any stock you can begin to realize how stock options offer you that advantage.
Stock options offer you an enormous advantage in profiting from the markets you must understand the concept of time in how it applies to option trading. Though they vary a bit, stocks offer different types of options with different time periods on them. These time periods, or what is commonly referred to as expiration periods, range from 30 days out to as long as 3 years with expiration days occurring every third Friday of calendar month. In my opinion, it is vital for you to understand the average holding days for your option trades so that you purchase the proper option so that it has enough time on it so you have time to profit from you position. If the average holding period is seven days and it is the middle of the month then purchase the next month's options so that you have 2 weeks plus another month in order to give your option position enough time to profit. Any option under 30 days till expiration is rapidly disintegrating in value due to time decay.
The other success factor you must come to understand when trading options is understanding strike prices. Strikes are terms assigned on the price of an underlying stock of a publicly traded company. If, for example, ABC company's share price is at $50 its strike prices on it's available options might be a $45, $50, and $55 which you can observe in the price tables of any financial newspaper. Now, each strike price has certain pros and cons depending in large part your particular option strategy but, for now, knowing what strike prices are and understanding how to implement them in your trading decision process will you help you make the most effective selection choice.
Understanding stock options and their role in your investment choices provides you with enormous potential for high returns as well as limiting your risk. There flexibility allows you to potentially profit from rising markets, falling markets, markets that are range bound, and protecting your stock portfolio from unexpected volatility in the markets. Take some time and reread this article as well as similar articles along with studying any financial newspaper that offers price option tables. The time you invest in understanding these powerful investment tools can help you take advantage of their enormous potential and improve your bottom line.
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