Stock option trading is a popular way to trade the markets. Since there are more variables involved than simply buying a stock, stock option trading is often believed to be too complex or advanced for the average trader.
It's true that there are more things to consider when buying and selling options, but options trading can be kept simple. In this article we'll cover stock option trading information you should know, and why stock option trading is a powerful alternative to simply buying stock.
These are the main reasons traders are attracted to options trading.
- Opportunities with a small investment – You can open an account with as little as $2500. Depending on the option and the trading strategy, you can buy an option for as little as $1 (although with most trading you'll probably buy an option for $25 or more.)
- Strategies for ANY market direction – Depending on your market expectations, you can trade options that will make money when the market is going up AND trade options that will make money when the market is going down. Using slightly more advanced strategies you can even make money if the market is going sideways.
- Limited risk – When you are an option buyer, your risk is limited to the amount that you pay for the option.
- Greater potential reward – Although greater reward is typically accompanied by greater risk, the potential rewards are bigger compared to traditional stock buying and selling because of leverage.
An option is a derivative of an underlying stock, index or market. When trading stock options, an option contract allows a trader to buy or sell 100 shares of a particular stock. Like all contracts, the details of the contract are laid out prior to the option purchase. (NOTE: These details are simply standardized by the exchange so all buyers and sellers know the rights and/or obligations of the option that is being traded.)
All options will have the following components:
- Option Class – Options are grouped into two categories: Calls and Puts. A call BUYER has the right to BUY stock at a specified strike price. A put BUYER has the right to SELL stock at the specified price.
- Strike Price – This is the price that a CALL option buyer can BUY a stock at. This is also the price that a PUT option buyer can SELL at.
- Expiration – All options have an expiration date. U.S. Stock options expire on the third Friday of the expiration month that is purchased.
- Underlying Asset – This is the market that the option contract applies to. The asset can be stocks, currencies, or an index. To keep it simple we'll focus on stocks.
Now that you know the basics of an option, you need to know how to select an option to trade.
Choosing the right option requires the following 5 steps:
- Step 1 - Choose a market.
- Step 2 – Identify the direction of the market.
- Step 3 – Decide on how much the market could move.
- Step 4 – Determine how long it will take for the move to occur.
- Step 5 - Select your options trading strategy.
Let's look at an example using the steps above.
Say that we've scanned the DOW 30 for stocks on the move and we see that Intel (INTC) is ready to move higher (you can use any strategy or our Power Crossover Method for determining the direction of the market).
- Step 1 – We want to trade INTC.
- Step 2 – We believe that INTC is ready to move higher using technical analysis (in this example we use the Power Crossover Method).
- Step 3 – With INTC stock currently trading at $25.01 a share, we believe the stock will trade up to $26.04 at a minimum (this exit is using our Power Crossover target but you can use any type of strategy or analysis to determine your target).
- Step 4 – We believe that INTC will make its move in the next 10 days (based on the typical duration of Power Crossover trends).
- Step 5 - If we believe that INTC will move higher in the next 10 days and we want to keep our risk limited, we will buy a CALL option.
Looking at an option chain below, we see that the price of the $25 strike April 2014 CALL is .64 cents. Since a basic option contract represents 100 shares of stock, the options quote is PER share and we will pay $64 (.64 x 100) to buy the CALL.
As a CALL option BUYER we have the right to buy shares of INTC for $25 a share any time before the option's expiration. If the stock moves up to $26.04 and we have the right to buy the stock at $25, our CALL option is worth $1.04 at a minimum. Since the purchase price of the option was .64 per share, we've made a $40 profit on the trade ($1.04 - .64 = .40 x 100 shares = $40).
The same steps can be used for a stock that is expected to move lower.
Say that we've scanned the DOW 30 for stocks on the move and we see that Nike (NKE) is ready to move lower (based on the Power Crossover Method indicators).
In the video below we'll show you how to analyze the market, and how to profit from a market that is dropping by buying a PUT.
With stock trading we need to follow the first TWO steps (determine the market and market direction). If we bought INTC stock at $25.01 a share and sold at $26.04 a share, we'd have a 4% return on our investment...not too shabby.
However, with a CALL option purchased for $64 we could sell the option for $104 at a minimum, resulting in a 62% return on the same move!
In the NKE example we could sell NKE stock as a short seller for $73.58. If we buy the stock back at $69.00 we have a +$4.58 profit on the trade and a 6% return on our money.
However, with a PUT option purchased for $224 we would be able to sell the PUT for $600 at a minimum when the stock is trading at $69. With a $376 profit ($600 - $224) we would have a 167% return on the same move!
The biggest differences between the two examples are leverage and time. A stock will not expire, but an option will. At expiration a CALL option will either have value (if the stock is trading above the strike price), OR expire worthless (if the stock is trading below the strike price).
A PUT option will have value at expiration (if the stock is trading below the strike price) OR expire worthless (if the stock is trading above the strike price). But we don't need to wait until expiration to close our positions. As an option buyer we can close the trade by simply selling the option any time before expiration.
Options trading is a powerful alternative to simply buying or selling shares stocks. The leverage involved makes options trading a very popular trading vehicle, but it's important to understand that leverage can work against you as well. Although there are advantages to selling options as well, buying options is a great trading approach for beginners because risk is always capped and reward is unlimited. Now you know the most import stock option trading information.
For more information on “How to Select the RIGHT Option” make sure to check out our Power Crossover Method & How To Swing Trade Options SPECIAL HERE.
On Monday March 31st, our INTC long call example hit our profit target of $26.04 a share.
When the stock was trading at $25.01 we had an opportunity to BUY the April $25 strike CALL for $64. Eight days later the stock hit our profit target of $26.04 and the April $25 strike CALL was trading at $104 for a $40 profit. In this example closing the trade for a $40 profit would result in a 62% return on the trade.
No representation is being made that any account will or is likely to achieve profits or losses similar to those shown above. The past performance of any trading system or methodology is not necessarily indicative of future results.