Why Should You Trade Stocks With Active Options?
Mark Wolfinger is an expert on options trading. He was an options market maker at the Chicago Board of Exchange CBOE for over two decades and has shared his expertise as the author of several books on the subject, including "The Rookie's Guide to Options," now in its second edition. Wolfinger has a bachelor's degree in science from Brooklyn College and a Ph. You know what an option is and you believe that you understand how it works.
But please demonstrate some patience before placing your money at risk. You are bursting with anticipation and cannot wait to begin raking in the money.
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However, it is not that easy. Money must be earned and please believe that no one gives it away. Here is a look at the pitfalls of buying options before you are ready to trade. Based on that anticipation, you open a brokerage account and buy 10 FAVR call options. You can hardly wait to see the money roll in. So what happens? Most of the time expiration day arrives and the options become worthless. The once eager, new options trader along with many experienced traders who should have known better , lost every penny invested.
The truly sad part is that your inclination was right on the money.
The only problem is that you correctly predicted the price increase and still lost money. It is bad enough to lose when your prediction is wrong, but losing money when it is correct is a bad result. Yet, it happens all the time in the options world. Unfortunately, this is a common result. So before buying options, please consider some things that you MUST understand about options. The purpose here is to make you aware of vital information. The details can wait until you have a better understanding of the basic concepts of options.
Call options: Learn the basics of buying and selling
Many factors go into the price of an option. A trader cannot simply "buy calls" and expect to make money when the stock price rises. Much more is involved. The problem is that brand-new traders are unaware of all the other factors that affect whether the trade will earn a profit or lose money. You expect the stock price to rise i. By how much do you expect the price to change? A history of the stock's average daily price change volatility provides a good clue to the correct answer. Be aware of just how volatile the stock price has been in the past. It is not necessary to buy OTM options , despite the fact that this is the choice of many traders.
They believe their prediction will come true and they want to buy the cheapest options. Our best guess is that most under-educated option traders want to own "a lot" of options, rather than just a few. It is similar to the thought process that makes someone buy lottery tickets. The seller or writer of options has an obligation to deliver the underlying stock if the option is exercised. If the writer also owns the underlying stock, the option position is covered. If the option position is left unprotected, it's naked. Based on your answers, the broker typically assigns you an initial trading level based on the level of risk typically 1 to 5, with 1 being the lowest risk and 5 being the highest.
This is your key to placing certain types of options trades.
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Screening should go both ways. The broker you choose to trade options with is your most important investing partner. Finding the broker that offers the tools, research, guidance and support you need is especially important for investors who are new to options trading.
Get trusted investing insights. As a refresher, a call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price called the strike price within a certain time period. A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires.
Depending on which direction you expect the underlying stock to move determines what type of options contract to take on:. If you think the stock price will move up: buy a call option, sell a put option. If you think the stock price will stay stable: sell a call option or sell a put option.
If you think the stock price will go down: buy a put option, sell a call option. If the stock does indeed rise above the strike price, your option is in the money. If the stock drops below the strike price, your option is in the money. Option quotes, technically called an option chain or matrix, contain a range of available strike prices. The price you pay for an option, called the premium, has two components: intrinsic value and time value. Intrinsic value is the difference between the strike price and the share price, if the stock price is above the strike.
Time value is whatever is left, and factors in how volatile the stock is, the time to expiration and interest rates, among other elements. This leads us to the final choice you need to make before buying an options contract. Every options contract has an expiration period that indicates the last day you can exercise the option. Your choices are limited to the ones offered when you call up an option chain. There are two styles of options, American and European, which differ depending on when the options contract can be exercised.
Holders of an American option can exercise at any point up to the expiry date whereas holders of European options can only exercise on the day of expiry. Since American options offer more flexibility for the option buyer and more risk for the option seller , they usually cost more than their European counterparts. Expiration dates can range from days to months to years.
Daily and weekly options tend to be the riskiest and are reserved for seasoned option traders. For long-term investors, monthly and yearly expiration dates are preferable. Longer expirations give the stock more time to move and time for your investment thesis to play out. As such, the longer the expiration period, the more expensive the option.
A longer expiration is also useful because the option can retain time value, even if the stock trades below the strike price.