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your alternatives when investing in the stock markets. They allow you Options?that you would not normally have when purchasing securities. ? You can shield your portfolio from market downturns. . ? You are able to position yourself to purchase stock during a price drop. ? You can prepare to profit from any market movement ?up, down, or sideways. ? You can benefit from market movement without incurring the cost of an outright stock purchase. BASIC CONCEPTS If you are new to options trading, consider starting out by looking over the Basic Options Concepts. As you read through the material you will begin to see that options are a simple way to manage the risk of your investments and that with only a little education, you too can put these simple and effective tools to work for you. ADVANCED CONCEPTS If you are a returning user or have previous experience with options, look at our Advanced Options Materials and Strategy pages. Here you will find an overview of some of the more sophisticated trading concepts. If you already know and understand options, you will want to see the different risk management trading strategies that we teach. Here you can see how you can profit in an up, down, or sideways Market.
BASIC OPTIONS CONCEPTS Congratulations on taking the first step towards a better understanding of option trading. At Optionetics, we know that learning to trade options often seems a bit overwhelming - but don 抰 worry, we 抣 l have you up and trading in no time at all! Our basic options section will provide you with a fundamental framework on which you can build your better understanding of what options are and how they work. Here is an overview of the topics that will be addressed:How Options Work: Learn what an option is and how it can control the risk of any investment. How to Use Options: Learn how to employ options strategies based on your personal market sentiments. Exiting an Option Position: Learn how to properly exit a position to maximize profit while minimizing risk. Call Options: Learn what it means to buy or sell a call option. Put Options: Learn what it means to buy or sell a put option. How Options Work
Options are the most versatile trading instrument ever invented. Since options cost less than stock, they provide a high leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income. Simply put, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy (call) or sell (put) the underlying stock (or futures contract) at a specified price until the 3rd Friday of their expiration month. There are two kinds of options: calls and puts. Call options give you the right to buy the underlying asset. Put options give you the right to sell the underlying asset. It is essential to become familiar with the inner workings of both. Every strategy you learn from this point on depends on your thorough understanding of these two kinds of options. There are no margin requirements if you want to purchase an option because your risk is limited to the price of the option. In contrast, option sellers receive a credit in their account for selling an option and get to keep this amount if the option expires worthless. However, option sellers also have an obligation to buy (put) or sell (call) the underlying instrument if their option is exercised by an assigned option holder. Therefore, selling an option requires a healthy margin. To trade options, you must be acquainted with the select terminology of the option market. The price at which an underlying stock can be purchased or sold if the option is exercised is called the strike price. Options are available in several strike prices above and below the current price of the underlying asset. Stocks priced below $25 per share usually have strike prices at 2 ?dollar intervals. Stocks priced over $25 usually have strike prices at $5 dollar intervals. The date the option expires is referred to as the expiration date. A stock option expires by close of business on the 3rd Friday of the expiration month. All listed options have options available for the current month and the next month as well as specific future months. Each stock has a corresponding cycle of months that they offer options in. There are three fixed expiration cycles available. Each cycle has a four-month interval: A. January, April, July and October B. February, May, August and November C. March, June, September and December The price of an option is called the premium. An option's premium is determined by a number of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility. An option premium is priced on a per share basis. Each option on a stock corresponds to 100 shares. Therefore, if the premium of an option is priced at 2, the total premium for that option would be $200 (2 x 100 = $200). Buying an option creates a debit in the amount of the premium to the buyer's trading account. Selling an option creates a credit in the amount of the premium to the seller's trading account: Example: Jane wants to buy a house. After a few weeks of searching, she discovers one she really likes. Unfortunately, she won't have enough money for a substantial down payment for
another six months. So, she approaches the owner of the house and negotiates an option to buy the house within 6 months for $100,000. The owner agrees to sell her the option for $2,000. Scenario 1: During this 6-month period, Jane discovers an oil field underneath the property. The value of the house shoots up to $1,000,000. However, the writer of the option (the owner) is obligated to sell the house to Jane for $100,000. Jane buys the house for a total cost of $102,000-$100,000 for the house plus the $2,000 premium paid for the option. She promptly turns around and sells it for a million dollars for huge profit of $898,000 and lives happily ever after. Scenario 2: Jane discovers a toxic waste dump on the property. Now the value of the house drops to zero and she obviously decides not to exercise the option to buy the house. In this case, Jane loses the $2,000 premium paid for the option to the owner of the property.
How Options Work Review 1. Options give you the right to buy or sell an underlying instrument. 2. If you buy an option, you are not obligated to buy or sell the underlying instrument; you simply have the right to. 3. If you sell an option and the option is exercised, you are obligated to deliver the underlying asset (call) or take delivery of the underlying asset (put) at the strike price of the option regardless of the current price of the underlying asset. 4. Options are good for a specified period of time, after which they expire and you lose your right to buy or sell the underlying instrument at the specified price. 5. Options when bought are done so at a debit to the buyer. 6. Options when sold are done so by giving a credit to the seller. 7. Options are available in several strike prices representing the price of the underlying instrument. 8. The cost of an option is referred to as the option premium. The price reflects a variety of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility. 9. Options are not available on every stock. There are approximately 2,200 stocks with tradable options. Each stock option represents 100 shares of a company's stock. How You Can Use Options
Options can be used in a variety of ways to profit from a rise or fall in the underlying market. The most basic strategies employ put and call options as a low capital means of garnering a
profit on market movement. Options can also be used as insurance policies in a wide variety of trading scenarios. You probably have insurance on your car or house because it is the responsible and safe thing to do. Options provide the same kind of safety net for trades and investments. They also increase your leverage by enabling you to control the shares of a specific stock without tying up a large amount of capital in your trading account. The amazing versatility that an option offers in today's highly volatile markets is welcome relief from the uncertainties of traditional investing practices. Options can be used to offer protection from a decline in the market price of a long underlying stock or an increase in the market price of a short underlying stock. They can enable you to buy a stock at a lower price, sell a stock at a higher price, or create additional income against a long or short stock position. You can also use option strategies to profit from a move in the price of the underlying asset regardless of market direction. There are three general market directions: up, down, and sideways. It is important to assess potential market movement when you are placing a trade. If the market is going up, you can buy calls, sell puts or buy stocks. Do you have any other available choices? Yes, you can combine long and short options and underlying assets in a wide variety of strategies. These strategies limit your risk while taking advantage of market movement. The following tables show the variety of options strategies that can be applied to profit on market movement: Bullish Limited Risk Strategies Bullish Unlimited Risk Strategies Bearish Limited Risk Strategies Buy Call Bull Call Spread Bull Put Spread Call Ratio Backspread Buy Stock Sell Put Covered Call Call Ratio Spread Buy Put Bear Put Spread Bear Call Spread
Put Ratio Backspread
Bearish Unlimited Risk Strategies Neutral Limited Risk Strategies Neutral Unlimited Risk Strategies Sell Stock Sell Call Covered Put Put Ratio Spread Long Straddle Long Strangle Long Synthetic Straddle Put Ratio Spread Long Butterfly Long Condor Long Iron Butterfly Short Straddle Short Strangle Call Ratio Spread Put Ratio Spread
It is of paramount importance to be creative with your trading. Creativity is rare in the stock and options market. That's why it's such a winning tactic. It has the potential to beat the next person down the street. You have a chance to look at different scenarios that they do not have the knowledge to construct. All you need to do is take one step above the next guy for you to start making money. Luckily the next person, typically, does not know how to trade creatively. Exiting an Option Position
Once you own an option, there are three methods that can be used to make a profit or avoid loss: exercise it, offset it with another option, or let it expire worthless. By exercising an
option you have purchased, you are choosing to take delivery of (call) or to sell (put) the underlying asset at the option's strike price. Only option buyers have the choice to exercise an option. Option sellers, on the other hand, may experience having an option assigned to an option holder and subsequently exercised. Offsetting is a method of reversing the original transaction to exit the trade. If you bought a call, you have to sell the call with the same strike price and expiration. If you sold a call, you have to buy a call with the same strike price and expiration. If you bought a put, you have to sell a put with the same strike price and expiration. If you sold a put you have to buy a put with the same strike price and expiration. If you do not offset your position, then you have not officially exited the trade. If an option has not been offset or exercised by expiration, the option expires worthless. If you originally sold an option, then you want it to expire worthless because then you get to keep the credit you received from the option premium. Since an option seller wants an option to expire worthless, the passage of time is an option seller's friend and an option buyer's enemy. If you bought an option, the premium is nonrefundable even if you let the option expire worthless. As an option gets closer to expiration, it decreases in value. It is important to note that most options traded on U.S. exchanges are American style options. In essence, they differ from European options in one main way. American style options can be exercised at any time up until expiration. In contrast, European style options can be exercised only on the day they expire. All the options of one type (put or call) which have the same underlying security are called a class of options. For example, all the calls on IBM constitute an option class. All the options that are in one class and have the same strike price are called an option series. For example, all IBM calls with a strike price of 130 (and various expiration dates) constitute an option series. Call Options Call options give the buyer the right, but not the obligation, to purchase an underlying asset. They are available in various strike prices depending on the current market price of the underlying instrument. Expiration dates can vary from one month out to more than a year (LEAPS options). Depending on the mood of the market, you may choose to buy (go long) or sell (go short) a call option. If you choose to buy or go long a call option, you are purchasing the right to buy the underlying instrument at whatever strike price you choose until the expiration date. The premium of a long call option shows up as a debit in your trading account. The premium amount represents the maximum risk a long call strategy can incur. Profit is made on a long call when the price of the underlying asset rises above the strike price of the call. You can then either exercise the call or offset it by selling a call with the same strike price and
expiration date. By exercising a long call, you end up with 100 shares per option of the underlying stock at the call strike price. You can then turn around and sell the underlying asset at the current (higher) price to garner a profit on the difference between two (current price strike price = profit). If you choose to offset the call option, the maximum profit is unlimited. The call's premium will increase in value depending on how high the underlying instrument rises in price beyond the strike price of the call. As the price of the underlying asset rises, the long call becomes more valuable because it gives you (or the person you sell it to) the right to buy the underlying stock at the lower strike price of the call. That's why you want to go long a call option in a rising or bull market. If you choose to sell or go short a call option, you are selling the right to buy the underlying instrument at a particular strike price to an option holder. Selling a call option prompts the deposit of a credit in your trading account in the amount of the call's premium-a limited profit. You get to keep this credit if the option expires worthless. Thus, to make money on a short call, the price of the underlying asset must stay below the call's strike price. If the price of the underlying asset rises above the short call strike price, it will be assigned to an option holder who may choose to exercise it. This gives the option holder the right to buy 100 shares (per option) of the underlying stock from the assigned option buyer at the strike price of the short call. This means that the option seller must buy the underlying asset at the current price and sell it at the call's lower strike price to the assigned option holder, thereby incurring a loss on the trade (current price - strike price = loss). The maximum loss is therefore unlimited to the upside, which is why selling "naked" or unprotected call options comes with such a high risk. However, experienced traders who do choose to short call options would be wise to do so in a stable or bear market. Call options give you the right to buy something at a specific price for a specific time period. However, if the current market price is more than the strike price, the call option is in-themoney (ITM). If the current market price is less than the strike price, the call option is out-ofthe-money (OTM). If the current market price is the same as (or close to) the strike price, the call option is at-the-money (ATM). Example: A local newspaper advertises a sale on VCRs for only $129.95. The next day Jane goes down to the electronics store intending to purchase a VCR at the advertised price. Unfortunately, by the time she arrives, the VCR is already out of stock. The manager apologizes and gives her a rain check entitling Jane to buy the same VCR for the advertised price of $129.95 anytime within the next two months. Jane has just received a long call option which gives her the right, but not the obligation, to purchase the VCR at the guaranteed strike price of $129.95 until the expiration date two months away. Scenario 1: A few weeks later, Jane return's to the store to exercise her rain check. The same VCR is now in stock, priced at $179.95. Jane approaches the store manager who agrees to honor the rain-check and sell her a VCR for the advertised price of $129.95. Jane has just saved $50. Her long call option was in-the-money.
Scenario 2: A few weeks later, Jane returns to the store and finds the VCR on sale for $119.95? Her rain check is now worthless because she can simply purchase the VCR at the reduced price. In this case, Jane's call option expired worthless because it was out-of-themoney. Just because you own a long call option doesn't mean you are under any obligation to use it. Scenario 3: Jane's friend Jeff phones and mentions that his VCR has just broken. She tells him about her rain-check and agrees to sell it to Jeff for $5 (the option premium). The strike price is still $129.95 and the expiration date is 2 months out. However, Jeff is taking a risk. The VCR might be priced lower than the $129.95 strike price in which case the rain-check is worthless and Jeff loses $5.
Call Option Review 1. Call options give traders the right to buy the underlying stock at the strike price until market close on the 3rd Friday of the expiration month. A call option is in-the-money (ITM) if its strike price is below the current price of the underlying stock. A call option is out-of-themoney (OTM) if its strike price is above the current price of the underlying stock. A call option is at-the-money (ATM) if its strike price is the same as (or close to) the current price of the underlying stock. 2. Buying Calls - If bullish - believe the market will rise - buy (go long) calls. Buyers have rights. A call buyer has the right, but not the obligation, to buy the underlying stock at the strike price until the expiration date. If you buy a call option, your maximum risk is the money paid for the option, the debit. The maximum profit is unlimited depending on the rise in the price of the underlying asset. To offset a long call, you have to sell a call with the same strike price to close out the position. By exercising a long call, you are choosing to purchase 100 shares of the underlying stock at the strike price of the call option. 3. Selling Calls - If bearish - believe the market will fall - sell (go short) calls. Sellers have obligations. A call seller has the obligation to sell 100 shares of the underlying stock at the strike price to the person to whom the option was sold, if that person chooses to exercise the call option. Sellers have obligations. If you sell a call option, your risk is unlimited to the upside. The profit is limited to the credit received from the sale of the call. When selling calls, make sure to choose options with little time left until expiration. Call sellers want the call to expire worthless so that they can keep the whole premium. To offset a short call, you have to buy a call with the same strike price to close out the position. Put Options Put options give the buyer the right, but not the obligation, to sell an underlying asset at the strike price until market close on the 3rd Friday of the expiration month. Just like call options, put options come in various strike prices depending on the current market price of the underlying instrument with a variety of expiration dates. Expiration dates can vary from one
month out to more than a year (LEAPS options). However, unlike call options, you might consider going long a put option if you expect market prices to fall (bearish). In contrast, if you are bullish (expect the market to rise), you might consider selling a put option. If you choose to buy or go long a put option, you are purchasing the right to sell the underlying instrument at whatever strike price you choose until the expiration date. The premium of the long put option will show up as a debit in your trading account. The cost of the premium is the maximum loss you risk by purchasing a put option. The maximum profit is limited to the downside as the underlying stock falls to zero. A profit can be made in one of two ways if the underlying market declines. By exercising a put option, you are short 100 shares of the underlying stock. If and when the underlying stock falls below the put strike price, you can exercise the put to short the shares at a higher price and then buy the underlying stock at a cheaper price to cover the short and exit the trade (strike price - current price = profit). The second technique for profiting on a put comes from offsetting it. If the price of the underlying stock falls, the corresponding put premium increases and can then be sold at a profit. If you go long a put option and the underlying security (index or stock) increases in price, the value of the put will fall. Then you can either sell the put at a loss or let it expire worthless. If you choose to sell or go short a put option, you are selling the right to sell the underlying stock at a particular strike price to an option holder. The premium of the short put will show up as a credit in your trading account. In most cases, you are anticipating that the short put option will simply expire worthless on the expiration date so that you can keep the premium received. The premium amount is the maximum profit you can receive by selling a put option. If the underlying stock falls below the put strike price, the put will most likely be assigned to an option holder who may choose to exercise the option. The option seller then has an obligation to buy 100 shares (per option) of the underlying stock at the put strike price from the option holder. You will then be long 100 shares of the underlying stock and your loss depends on how low the price of the underlying stock falls as you try to sell the shares to exit the position. Experienced traders who choose to go short put options do so in a stable or bull market because the put will not be exercised unless the market falls. Put options give you the right to sell something at a specific price for a fixed amount of time. A put option is in-the-money (ITM) when the strike price is higher than the market price of the underlying asset. A put option is at-the-money (ATM) when the price of the underlying is equal (or close) to its strike price. A put option is out-of-the-money (OTM) when the price of the underlying security is greater than the strike price. Example: Jane opens a small travel business that specializes in island vacations. The manager of a a local business agrees to purchase 100 trips to Hawaii in January for $300 round-trip as perks for his employees. Jane's computed total cost of each trip is $200-a $100 profit on each trip which locks in a guaranteed profit of $10,000 for her initial period of operation. In effect, the guaranteed order is a put option.
Scenario 1: As luck would have it, just as November rolls around, a competitor offers the same trip for only $250. If Jane didn't have a put option agreement, she would have to drop her price to meet the competition's price, and thereby lose a significant amount of profit. Luckily, she exercises her right to sell the trips to Hawaii for $300 each and enjoys a healthy profit in the new year. Jane's put option was in-the-money in comparison to the price of her competitor. Scenario 2: Jane gets a call from another client who needs to set up 100 trips in January to fulfill obligations to his management team and is willing to pay up to $400 per trip. Since Jane is under no obligation to sell the trips to her first customer, she agrees to sell them for the higher market price and makes a total profit of $20,000 on the deal.
Put Option Review 1. Put options give traders the right, but not the obligation, to sell the underlying stock at the strike price until market close on the 3rd Friday of the expiration month. A put option is inthe-money (ITM) if its strike price is above the current price of the underlying stock. A put option is out-of-the-money (OTM) if its strike price is below the current price of the underlying stock. A put option is at-the-money (ATM) if its strike price is the same as (or close to) the current price of the underlying stock. 2. Buying Puts - If the options trader is bearish -- believes the underlying stock or index will fall in price -- the trader can buy (go long) puts. When the put is purchased, it is called an opening transaction. Now, the buyer has rights. A put buyer has the right, but not the obligation, to sell the underlying stock at the strike price of the option until the expiration date. Furthermore, if a trader buys a put option, the risk of the trade equals the money paid for the option, or the debit. The profit is equal to the fall in the price of the underlying asset. The profit will result if the underlying security moves lower. The profit is limited because the underlying asset will not fall below zero. Finally, to offset a long put, the trader will sell a put with the same terms (strike price and expiration) to "close" out the position. On the other hand, if the trader exercises a long put, then he or she is selling, or short, the underlying stock or index at the strike price of the put option. Selling Puts - If the options trader is bullish -- believes the market will rise -- the trader can sell (go short) puts. Sellers have obligations. A put seller has the obligation to buy 100 shares (per option) of the underlying stock at the put strike price. In other words, the option seller must be ready to have the stock "put" to him or her. The put seller's risk is the drop in the stock price, which is limited to the stock falling to zero. The profit equals the credit received from the sale of the put. Put sellers often prefer options with little time left until expiration because they want a put to expire worthless. In that way, the seller keeps the entire premium. A short put is offset by purchasing a put with the same strike price and expiration to close out
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