how does stock options trading work?
how do you trade stock options? how does it work exactly, all i know is how to trade stock. helpful links would be appreciated as well as a thorough explanation.. what is the risk and reward. How is it different than trading stocks? thanks
options in a nutshell…..This is an explaination of equity options. Basics – Strike price is the price paid at execution or which intrinsic value is based. Expiration- The date the contract expires. Options have cycled expiration dates, all of which expires on 3rd Saturday of the month. The last day to trade is the third friday of the month. A contract represents 100 shares. There are puts and calls. There are four types of options and depending how ther are initiated they are either bull or bear strategies. Each contract represents 100 shares of the underlying equity. The four are: Long Calls – This is buying the right to purchase a stock at a fixed price within a predetermined period of time. This stategy is most commonly used to control a larger position of a stock then you could by simply buying the stock outright. I will use Intel symbol “intc” in all examples to illustrate. fridays price was 21.50 a share. To buy 100 shares of intel you would need $2,150. However for 1.85 per share or $185 you can control 100 shares of the November 20 Calls. This contract gives you the right to purchase 100 shares of intel @20 between now and Nov. 18th when the contract expires. Notice you have to pay a .35 premium for each share. However, if intel goes to 25 your options would have a minimum value “intrinsic” of $5. Which is a 65% return. When the stock only went up 22%. With long calls your loss is limited to the original invesment…$185. Max gain is theoritically unlimited. There are two ways in which to realize the gain in your position. You can simply sell the option contract for its current value which would be its “intrinsic” or true value plus any time value that still remains. In the example above, if the gain in intel happened the first day of ownership. The option would be worth more than $5 because of the the time premium still remaining. The time value would be less than $.35 You can also exercize you call and purchase 100 shares of intell at $20 per share. You would use this if you wanted to keep the shares for a longer period of time or to delay to the capital gain.
Long Puts- Would be used in the same manor as calls. With puts you are looking for a stock to trade down. Puts give you the right to sell a stock at a fixed price within a fixed time period. With Long puts your loss is also limited to the original investment.
Now Short Options are where the game gets more complicated and should only be used by an experience options investor. Your risks are much greater with short or “naked” options. An easy way to differentiate is with long calls and puts you are the gambler, risking a small amount of money to potentially win big. In selling options you are the booky. However, your capital exposure is much greater. Naked or short calls are the riskiest option strategy. Selling to “open” calls is giving someone the right to buy stock at a fixed price for a certain time period. It is a bearish strategy and you are betting the stock will not go up over time. In return if you are correct you get to keep the premium. Go back to the origianl intel example. If intel trade down below 20 you would get to keep the 185. However if the stock trade above 21.85 the loss matches the difference penny for penny. Stock goes to 25. The short call writer “seller” looses 3.15 per share. The loss is theoretically unlimited . Very risky.
Now shorting or selling “naked” puts is a very useful way to purchase a security at a discount. With short puts you are selling someone the right to sell you their shares at a fixed price. You are committing yourself to purchase a stock. Lets say you wanted to own intel stock. However you think 21.50 a share is a bit pricey. You would be willing to buy intel at 21. Instead of tring to time intel and placing a limit order to buy at 21. You can sell a dec 22.5 put for $1.50. Your cost basis for intel if forced to purchase would be $21 (22.5 less the 1.50 premium you collect for the naked put) If you are wrong about intel and it continues up above 22.5 you get to keep the $1.50. If it trades down below 21 you will still have to pay net 21 per share. But than you own the stock and you can wait as long as you want to see the stock back above your $21 cost basis.
Options are very useful in a more conservative way. They can be used to cover an existing Long or Short position of a stock. Cover calls are used for long equity positions. Covered Calls, in return for giving up the profits above a fixed point you get some down side protection.
A “Married put” is buying a put to place a floor on the loss that can be experience with a long position.
A Simple Trading System Using Stock Options
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