Options can enhance an investor’s portfolio by providing protection, profits, and leverage. However, the learning curve for options trading is steeper than stock trading.
Understanding the Language
With options, there are four available actions: buy calls, buy puts, sell calls, sell puts.
Buying a call option means you’re potentially going long on the underlying stock, and selling a naked call option means that you’re going short on the underlying stock. In contrast, buying a put option means you’re going short, and selling a naked put means you’re going long.
Different terms are used to identify buyers and sellers – buyers are called holders and sellers are called writers. Holders are not obligated to do take control of the stock, only if they desire to do so. However, writers must sell or buy the option before it expires if the holder exercises the contact. This means that writers are at risk of losing more than just the price of the options.
The 3 Main Factors that Decide the Price of an Option
The price of an option depends on the perceived value of the asset in the future. The greater the probability of a reasonable price increase, the more expensive the option.
Another factor affecting the price is the time until expiration. Less time means, less value because there will be a lower chance of price improvement. As a consequence of this, the same option will be cheaper if it expires in one month compared to one year.
Another factor linked directly to the price is implied volatility, which is the underlying assets chance of a price fluctuation, the more a stock moves in price the more likely the option can finish within the money.
In terms of shares available to trade, most US exchanges offer a contract of buying or selling 100 shares. In terms of value, options have an intrinsic value which is the in-the-money amount, or the amount above the strike price of the stock in case of a call option, and extrinsic value, which is the time value.
American vs. European Options
An American call option allows holders to ask for delivery of the underlying stock or security whenever they want as long as they are within the time of the contract.
The difference between American and European options is that traders of European options can only exercise the options on the expiration date.
Rookie Options Trading Mistakes
Most newcomers focus on out-of-the-money (strike price higher than the stock price), short-term calls. While such short calls are a popular option, they may not be the best way to get into options trading as they have one of the lowest probabilities of successes.
The reason why beginners shouldn’t select out-of-the-money calls is that they not only have to be right about the direction in which the stock will move but also be right with their timing. In addition to direction and timing, they need to take into account option cost, commissions, and taxes.
With out of the money short-term calls, traders are hoping to see a strong movement in less than a month to make a return on the investment. In most cases, the price does not reach the strike price.
To illustrate this point, let’s consider the example. Here we have a $60 stock, if an investor buys a 65-strike price option and the stock trades up only to $64 there won’t be a return on investment because of a failure to estimate how much the stock will rise.
However, just because this options strategy doesn’t have the highest winning percentage doesn’t mean that it should be discarded all together as it can be combined with other option position to increase the probability of success.
Advanced traders often have a higher success rate by combining several option strategies together to minimize cost, limit risk, and beat average market returns.