Options Trading 101
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by: amaramar
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Options trading is much like stock and bond trading. Trading strategies can range from a simple buy and hold to a highly advanced use of technical analysis. Then there is everything in between. Although options trading may be similar to stock and bond trading, there are some distinctions that make options a desirable investment opportunity.
They are a contract that confers the right to buy which is a call option, or sell, a put option an instrument. This instrument could be a stock or bond, but the instrument is sold at a predetermined price which is referred to as the strike price, on or before an expiration date.
Options that may be exercised at anytime prior to the expiration are referred to as American options. European options, on the other hand, are exercised precisely on the expiration date. Although the terms refer to regional or geographical implications, the exact association or meaning has been long forgotten through the passage of time. Still, American style options are written for stocks and bonds while European options are generally written on indexes.
When options expire, they do so on the Saturday following the third Friday of the expiration month that is on the contract. Investors will be hard pressed to find a broker who is available on a Saturday, plus, the US exchanges are closed. These factors force that expiration day to be pushed up on day - The Friday before the expiration.
When determining a selling strategy for an option, there are two choices. The holder can keep the option until its maturity date or expiration date, or they can sell before the expiration date. For ease of understanding, this information will pertain to American options only.
Most investors do hold their options until the mature then they trade the underlying asset. Say the buyer purchased a call option at $2 on a stock with a strike price of $25. Options contracts are typically set on 100 share lots. Therefore, in order to purchase the stock, the total investment is:
($2 + $25) x 100 = $2700 (Ignoring commissions.)
This strategy works as long as the market price remains above $27.
If the investor speculates that there is a peak in the price before the expiration date; if the price has risen above $27 but appears to be on the decline with no hope of recovering then it is preferable to sell.
On the other hand, if the market price is below the strike price and the option's expiration date is near or the price is expected to decline further, then it would also be a desirable condition for selling. In this case, it is best to sell before the price falls any lower to curb any further loss. The loss can be minimized, however, by using it to offset capital gains taxes.
Of course, another alternative is to allow the contract to expire. Options are not like futures. The investor is under no obligation to buy an asset or sell it; they only have the right to do so. When taking into account the premium, strike price and current market price, it may yield a more minimal loss for the investor to simply "eat the premium."
It should be noted that options do still carry a certain degree of risk. These uncertainties are the same as are associated with stocks. In reality, stock prices can rise or fall, a little or a lot and show erratic, unpredictable behavior over fluctuating time frames, but, these risks are exacerbated with the fact that, like bonds, options have an expiration date.
The reality is that the price of the option itself may change over the passage of time. The contracts are traded just like stocks or bonds and both the price of the underlying stock amount and the amount of time left until the expiration date are both influential factors in the rate and amount of change.
A way to offset the premium loss or even profit is to sell the option but not the underlying asset.
About the Author
Visit 123OnlineTrading.com - Options, Stocks, Forex to find books, tips and advice about online options trading. Besides a large selection of free educational articles you can also find powerful books about online trading in general. Other Resources: 123OnlineStockTrading.com - Stock Trading Links
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