Amar Mahallati asked:


Options are contracts on an underlying trading instrument such as shares of stock, bonds, a commodity, a mortgage loan and many others. However, there are common features among all options. It does not matter if it is a share of stock or a mortgage loan; they all have certain things in common. One such commonality is the contract feature that specifies what the option owner has actually contracted.

Options traders have two situations that may influence their buying and selling: calls and puts. There terms are used to indicate specific behaviors of options at various points of the option’s life.

CALLs

A call bestows on the contract holder the right to purchase an asset at a particular price on or before the option’s expiration date. This is only a right to buy, it is not an obligation. The call owner always has the choice to allow the option to expire. This does mean that all the initial money that was invested in purchasing the contract is lost, but the choice still stands.

Call buyers are gambling on the underlying asset’s behavior; that it will increase in price before it reaches its expiration date. Also that it will not only rise, but will rise significantly enough to show a profit.

In order to show a profit, the price must rise enough to cover the difference between the market price and the strike price. The strike price is that price at which the stock must be bought. But, because the option has a cost attached to it, the price must exceed that amount enough to cover the additional amount. This cost is referred to as the premium.

The premium of an option, whether call or put, is determined by a variety of elements. These include, but are not limited to, the price of the underlying asset, the strike price and the time remaining on the option.

The time remaining on an option is vital. The shorter the time remaining, the greater the risk and vice versa. For example, if there are 90 days left to exercise an option, the risk is somewhat lower than if there was only 1 day left. This is because within that 90 day period the price could rise enough to show a profit. With just 1 day remaining, however, the odds are considerably lower.

For example, on April 1, MSFT (Microsoft) has a market price of $27. Call options for June 30 are selling for $3 with a strike price of $30. One contract for 100 shares is purchased.

If the contract is held until the expiration date, the trader either loses $300 ($3 X 100, the initial price of the contract not including commission) or the trader can purchase the underlying stock at $30. If the current market price was $35, then the trader has profited by $200 ($35 - ($30 + $3) = $2 per share X 100 shares, sans commission).

When the market price of a share rises above the strike price, the option holder is “in the money.” If the market price drops, then the holder is “out of the money.”

PUTs

A put gives the option buyer the right to sell an asset at a particular price by a specified date. Again, like a call, this is a right, not an obligation.

Put buyers are anticipating the stock prices to fall before the option’s expiration date. Therefore, in such cases, the market price must drop below the strike price in order to show a profit from exercising the option. For simplicity purposes, the cost of the put is ignored. Under those circumstances the option holder is in the money.

Still using the previous example, maintain the same situation, but this time the option is a put. If the market price falls to $25, the profit would be as follows:

First, $3 x 100 = $300 = Cost of put, excluding commissions.

Purchase 100 shares at $25 per share = $2,500 this is to repay the broker ‘loan’ (this broker loan is a part of shorting stock which is borrowing shares you don’t own, then repaying later).

Sell 100 shares at Strike price = $30, 100 x $30 = $3,000

Profit = ($3000 - $2500) - ($300) = $200.

It is the broker who handles the underlying mechanics. All the investor has to do is order the trades at a given time and date.

Wise investors do their homework and research their strategies, no matter if they are investing in calls or puts. Options trading does present risks and is rather complicated when compared to simple stock trading, although all trading contains an element of complication and risk. But investors in this line should study the history, volatility and other vital factors of both the option contract and the underlying asset.

A trader should never enter the market blindly and trade without doing the proper research first. The failure to do adequate research and go into the trade informed puts the trader at a must greater risk of losing money and not showing a profit.



ARCHIE

Craig Thornburrow asked:


Options trading is an investment vehicle for experienced investors, who track their investments proactively. It is not a suitable vehicle for investors looking to maintain assets without direct management, as it’s very much a timing related purchase and float. Options trading is an excellent technique for using financial leverage to make bigger purchases.

A very simple example of an options trade would be this: If you’re selling a commodity worth $100,000 (say 1,000 shares of a stock worth $100 per share), and a prospective buyer likes the price, they can offer to pay for an option to buy all of those commodities, while spending the time researching other investments. Say, for example, they’re offering you $1,000 to hold that price for them while they gather the rest of the funds, which they say will take three months.

When three months passes, they either pay the remaining $99,000 for the shares of the stock, or forfeit the option. If the stock goes up in price to $110 per share from $100, they can either buy the stock, or sell the option to someone else for the difference between the old price and the new price. Either way, the person holding the option stands to make a tidy profit.

Options trading has its own set of terminology, which we’ll get into a bit later, but the basic premise is this: You buy an option to purchase a stock or commodity at a given price; the option expires after a given time period (American style options trading), or the option must be exercised on a specific date (European style options trading).

There are two principle types of options that are traded. Calls increase in value as the stock price rises, and puts increase in value as the stock price declines. (There’s a lot of fiscal mathematics behind both of these, but the layman’s explanation will suffice.) In most cases, options are sold to other investors just before they expire; most options traders don’t end up holding shares in the stock they have options for; the options are bought, sold, liquidated and transacted before their expiration dates. It is possible to have both call and put options on the same commodity or stock; this is a “straddle” strategy.

Options trading is not a casual investment strategy; it’s a strategy used by people who are investing as their profession, or who intend to manage their own wealth directly. The benefits of options trading is flexibility, coupled with (in the case of put options) a bit of a countercyclical strategy for bear markets.

The key to options trading is market research on specific stocks; an options trader will be researching stocks that are either slated for a price spike (call options) or are likely to undergo a price decline (put options). How quickly these options express themselves is a measure of market volatility, and most options traders will try to take a neutral position – they’ll put in put and call options to cover both directions, and to cover themselves against broad market trends.

Options arbitrage is a lower risk strategy done by floor traders, and can be short term profitable, with good liquidity. The aim is to swap options with other traders before certain factors influence the market, or to get rid of underperforming options while still getting some profit out of them. Options arbitrage is perhaps the best place to start in options trading for a novice.



Benjamin