Learn About Options
Introduction to Option Trading
Trading stock options is a much different game from trading the
underlying stocks. When options are traded for appreciation, it is a
game of leverage, with big risks and associated big returns. One of
the attractions of trading options is that you do not need a large
amount of starting capital. It's also easy to play both sides of the
market by purchasing call options for the upside and put options for
the downside.
Rules of the options game
Remember that in the game of options time is your enemy. If the
market moves against you, then get out of the position and take your
lumps. Save the remaining principal for the next play.
When you play options, you should use stop prices. Watch for sufficient volume in the option to allow for liquidity
when it's time to release the position. Adequate volume would be an
average volume of 100 contracts a day.
Buying options for short-term appreciation
This strategy involves the purchase
of put or call options with the expectation that the options will
increase in price. The buying of options provides great leverage but
the trader runs the risk of the loss of all committed funds.
The premium or price of an option responds directly to changes in the
price of the underlying stock.
Option premium is also affected by
market conditions, the public's appraisal, and very directly by the
remaining life of the option. This latter aspect of premium is called
the time value. As the calendar moves toward the expiration date, the
time value diminishes and the value of out-of-the-money options will
go to zero. For the buyer of options, a horizontal market is doom, and
time is the enemy.
The degree of leverage associated with a particular option depends on
several factors. Strike price and the time remaining to expiration are
both important factors. Leverage is always greater for out-of-the money
options and decreases as the option moves deeper in the money.
(The terms out-of-the-money and in-the-money refer to the
strike price of the option relative to the current stock price. A call is
out-of-the-money if the stock is below the strike price, and in-the money
if the stock is above the strike price. The opposite is true for a
put.) Leverage also increases with decreasing time to expiration.
Another factor which influences leverage is the volatility of the
underlying stock. More volatile stocks have higher premiums and
lower volatility generally translates to higher leverage. However, this
does not necessarily mean that you should look for low volatility when
buying options. Low volatility implies a stock with relatively small
ability to move and, therefore, limited gains.
Recommended reading
Gastineau, Gary L. THE OPTIONS MANUAL, 3rd ed. McGraw-
Hill
McMillan, Lawrence G. OPTIONS AS A STRATEGIC
INVESTMENT New York Institute of Finance, New York
Cox, John C. and Mark Rubinstein, OPTIONS MARKETS,
Prentice-Hall, Englewood Cliffs, NJ
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