Options are contracts that make it possible for option buyers to buy a share at the fraction of the price it would cost otherwise on a specific day or before that day. Another option for the option buyer is to sell a security at a particular price on or before a certain day. Options are most frequently used in the stock market or in the equity market. However they can also be found in Forex options markets, commodity markets and in futures. There is more than one kind of option. There are exotic options, also known as FLEX and there are stock options that may come from an employer as a form of compensation. It is the latter type of option that we will turn our attention to here. What does to mean to trade options ? It is a common practice for investors of all kinds to use option contracts to hedge positions. They may also use them to purchase and sell stock. However the vast majority of option investors are known as speculators.

Speculators

What are speculators? They are those who most often do not have any plans to exercise the option contract. This contract is one that makes it possible for an underlying stock to be bought or sold. What they wish to do instead is to capture a move that takes place within the stock without having to spend a great deal of money. Having an edge works to your advantage when it comes to purchasing options. One of the biggest mistakes made by option investors is buying them in anticipation of an event that is receiving a great deal of attention such as an earnings announcement or the approval of a new drug. Be aware that option markets are much more efficient than many speculators believe them to be.

What You Need to Know

Stocks have what is known as intrinsic value. Those interested in buying stocks often use fundamental analysis to review a company’s financial statements and balance sheets. Reviewing these things can lead to understanding the intrinsic value inherent in a given stock. Often when analysts upgrade a stock they will sometimes provide a price target for it. They also may offer a time frame that is vague in nature. These kinds of option buyers then tend to be more inclined to choose long-term contracts that are anywhere from six months to 12 months in length.

There is also what is known as the technical analysis of a stock. Some stock options buyers choose this because it provides a means of determining a specific price movement of the stock. Chart readers of this sort are able to adequately identify areas of both supply and demand for stock shares. In the world of options this is known as support and resistance. Generally speaking stocks move up when there is a greater demand for them and they move down when there are too many of them. Being able to identify the supply and demand modifications of stocks is good because it helps to determine the time frame and the movement of them.

Understanding Intrinsic Value

The price movement of a stock is the biggest driver of its success when it comes to buying an options contract. For example, if you are a call buyer then it is important for you that the stock rises. On the other hand a put buyer needs the price of the stock to fall. The option’s premium is composed of two elements- there is the intrinsic value and the extrinsic value. The intrinsic value is comparable to equity in a home. It can be defined as the percentage of the premium’s value that is driven by the stock price overall.

Let us use a concrete example to illustrate the point. You own a call option on a stock that is presently trading at $47 per share. To make this simple to understand let’s say that you own a call with a strike price of $45. The option premium for it is $3. Due to the fact that the stock happens to be $2 more than the price of the strike that means that $2 of the $3 premium is known as intrinsic value (or equity as it was described previously), while the $1 that is left is extrinsic value. In order to determine how much the stock must move for more profit to be seen you can add the price of the premium to the price of the strike. It would look like this: 3 + 45 = 48.

Extrinsic value is often referred to as the time-value component of the option price. It is the additional cost that is paid out for the privilege of owning the option that is above and beyond what its intrinsic value is worth. Options that have intrinsic value are described as being “in the money” (ITM) while those that have no intrinsic value but lots of extrinsic value are described as being “out of the money” (OTM). Options that have plenty of extrinsic value tend to be less sensitive when it comes to the movement of stock prices. Options with plenty of intrinsic value are more in balance with the price of a stock. The name given to the sensitivity of an option in terms of the underlying movement of the stock is known as delta. For example, a delta of 1.0 means that the option is likely to move dollar per dollar with the stock.

Understanding Extrinsic Value

Extrinsic value is sometimes referred to as time value. It is important to note however that this is somewhat of a misnomer. Extrinsic value is made up of implied volatility that fluctuates in so much as the demand for options fluctuates. However other influences affect it including stock dividend changes and interest rate shifts. Time value and implied volatility tend to be greatest influences than interest rates and dividends.

Time value is the part of the premium that is above the intrinsic value that an option buyer will pay in order to be the privileged owner of the contract. Over the course of time the time value premium becomes smaller as the expiry date for the option draws closer. A long option contract provides the option buyer with a greater time premium to pay for. The time value melts at a more rapid rate the closer to the expiry date that a contract is.

The Greek letter theta is what time value is measured by. Having efficient market timing is essential for option buyers because theta has a way of eating away at the premium regardless of whether the profit is good or not so good. A mistake that is often made by option investors is to let a profitable trade sit for such a length of time that theta has the opportunity to reduce the profits tremendously. That is why it is so important for investors to devise a clear exit strategy before purchasing an option.

Implied volatility is also an integral part of extrinsic value. Option investors often refer to this as “vega.” Supply and demand is what mainly accounts for vega moving in an upward or downward direction. When there is an influx of purchasing for an option contract this automatically forces the option price to go higher.

This in turn entices those who sell options to decide that it is time to take the other side of the trade. Vega or demand will often lead to the inflation of the option premium. This explains why such popular events as drug trials or earnings are often disappointing for option buyers because they end up being less profitable than anticipated.

To cope as effectively as possible with vega you must either get rid of it as fast as possible by choosing to go in the money (ITM) or you must anticipate the inflation of the premium and purchase ahead of the demand. If the demand drops off and the supply then increases then the vega will be reduced and this will lead to a percentage of the extrinsic value being deflated (a significant portion of it). These things all explain why an investor really needs to develop an edge when it comes to purchasing options.

When you buy options your goal is for it to lead to profit. There are two ways to make options buying as profitable as possible. First, you must determine an entry point for it before the price begins to move. The second thing is that you must strike while the iron is hot. To put it another way, you must purchase the option before its implied volatility begins to inflate. Be aware that implied volatility has a tendency to inflate the most during bearish turns (which means when prices are expected to fall). This can provide put buyers an advantage over call buyers.

Making a profit in the middle of a poor economy is a very hard thing to do; even the best traders can have an impossible time of it.  Oftentimes investors will buy stocks in the hope of recovery only to be left with even worse losses.  Trading and buying in this way can rob you of potential capital for the economy gets better.

But there is a way to still make these risks with less money and limit the amount of money you can lose if the economy doesn’t recover as you expect it to.  And that answer is to trade stock options.  Yes it is true that when you trade options it is risky and you could potentially lose all of your investment.  The part that people tend to overlook is that to trade stock options is a way of trading in a risk-limited manner for a potentially big profit.  And you can control potential losses to a smaller amount.  When you buy stocks, you are paying a specific price for each stock.  When you buy stock options, you are buying the right to buy or sell a certain number of stocks at a predetermined price.

So if you replace buying the actual stock with buying a call option, you can control the profits on that stock.  If the stock market improves then you simply call in your option contract and make the profit.  If the stock market continues its decline then you lose nothing more than your original investment.  Had you bought the actual stock and the market continued to decline, you could have potentially lost a lot more money when you were forced to sell them.

You need to be extra cautious of what options you are buying in a bad market.  Not only should you thoroughly research the options themselves, but research the history of those options.  Look at the company’s stock prices for at least the last six months.  This should give you a good idea of how the stock prices are behaving in the down market.  When you learn to trade options, looking at how the stock prices behave is an important part of success.  It may also be a good idea to research the company as a whole.  If the company is about to go bankrupt, the last thing that you want to do is trade options for that company.  Not knowing what you’re buying is the best way to lose all your money.

If you are still unsure of your trading abilities, look into paper trade options.  Basically this is a company that allows you to create a faux options portfolio.  Then you can track the progress of stocks and practice buying and selling different types of options.  The best part is these sites are usually entirely free.  Hardly anything in the stock market is free, so you might as well take advantage of paper trade options.  Practice trading in a bad economy with paper trade options.  If you do well, then you might consider putting your actual money on the line and start to trade options for real.  If you find that the down market is just too volatile for you to get the hang of it, then you haven’t lose anything.

As a novice trader you probably aware of what an option is and how to use it.  But simply exercising your right to buy or sell stocks in not your only choice.  The contract also gives you the ability to trade stock options.  Trading gets a lot of press lately and it’s hard to know what to do and who you can trust.  One thing to understand is that it is not a get rich quick scheme where you should just immediately buy the options and then trade the option.  Yes, you can make a lot of money when you trade stock options, but many other people also lose a lot of money too.  There is a sequence of things you should do and make sure you have mastered before you dive into the world of trading options.

You should be able to pick a good stock first.  Any good option trader absolutely has to be able to analyze the stock market and pick a winning stock.  Stock options are a bit more complicated in that in order to successfully trade options you have to be able to accurately predict what a particular stock is going to do.  Since options are just an extension of normal stocks, you should practice with the normal stock first.

Reading about analyzing the technical and fundamental aspects of the stock market is also important.  Go to the library and read as much as you can.  There is a lot to learn in order to successfully learn to trade options.  Scour the Internet for as much information as you can and learn how other people do it.  If you simply jump in and start trading options you may find that you’ve overlooked the basics of stock analysis and take a loss when you finally trade the option.  There is lots of great information online and a few books specifically geared toward teaching you to learn to trade options.  Learn from others success and know the ins and outs of stock options as well as you can.

Typically only about 5% of traders will succeed with stock options, so don’t expect this to be an easy thing.  If you are thinking that you can pay a few hundred bucks and spend a day in a seminar and know it all, you would be wrong.  You will spend long hours not only researching the different stock options but watching and analyzing the market so that you know when is the best time to buy.  When you are first beginning you should use stock options as an extension of your stock portfolio.  This gives you the ability to make a few mistakes while you still have your portfolio intact and you’re not completely out in the cold.  Use the rest of your portfolio to offset some of those mistakes and generate some income.

You should also keep your strategy simple at first.  You will undoubtedly hear of strategies like delta neutral, back-spread, butterflies, calendars, etc.  Be aware these are Market Maker strategies.  They will not work on a retail basis and attempting to implement them will only lead to financial loss.  Keep a simple strategy; if a stock has been rising and all forecasts suggest that it will continue to rise…buy a stock option.  Then you can trade it once the stock rises again and you’ve made your profit.  Also know that it’s important to have proper amounts of capital.  If you want to trade stock options seriously then you should have at least $10,000 in capital.  And this capital should be no more than 10% of your overall portfolio.  Options are complex and you need to make sure you have enough financial cushion if you don’t do well at first.
Finally, have realistic expectations.  Most people would consider themselves successful at trading options if they make a 20% profit.  And expect that you will lose money.  Even people who have been trading options for 20 years that still lose money on trades.  It is simply part of the process and you will never have a 100% success rate.  It is an easy business to start but it’s a horribly difficult one to grow.

You are probably reading this article to learn how to trade options or you want to find out what trading options is all about. You may know someone who day trades options or perhaps paper trades options. The point is you want to know more about trading stock options.

To start with, what is a stock option? A stock option is not like holding shares in a company. Consider it to be more of a contract that will be settled at some point in the future. It is more of a contract between two parties.

Most importantly there is money to be made by trading options and just as important to remember there is money to be lost trading options. The potential for gain will always bring with it a measure of risk in investing and trading options. If you plan on trading options, make sure you understand fully the risk and downside of each trade.

When you own stock you actually own part or a piece of a company. An option is an agreement, or contract, where one party agrees to deliver something to another party within a specific time period and for a specific price , and therein lies the risk.

Options are extremely popular for one reason. Because they can help you get more for your money and provide investing leverage.. Instead of buying a stock outright, you can enter into an options contract or agreement, which can be much cheaper but have the same–or even better—results. Are you lost yet? You should be, it can be very complicated for people to understand.

However you can learn to trade options successfully as there are many online firms that trade options and educate their investors on how to trade options. Most are geared towards the individual investor. Before investing one dollar in options it is imperative that you learn how the process works and evolves over the course of the contract. We will provide more of that information n other articles