Learn to Trade Options

Looking for a great primer to options trading? In the following article Christopher Ebert doesan excellent job of laying out the basics of option trading. He includes a number of examples which make it simple to follow and easy to understand. Enjoy.

Options are a complex subject, and there are many experienced traders who discuss them in ways that are sometimes difficult for new traders to understand. With the ever-increasing popularity, many traders are discovering options for the very first time; and they have questions such as this one recently received from a reader:

I have a brand new virtual option trading account and don’t know anything about it. I see puts and calls, dates and prices. Could you explain a little about options, and how chose price/date.      Peter

Peter, you should be commended for your choice of virtual trading as a means of learning how to trade. Options have the capability of generating huge profits, but they can also wipe out an entire account very quickly if not used correctly. While virtual trading is not a substitute for live trading with real money, it is a valuable tool that can greatly reduce the losses many traders experience in their first year.

First, the basics: There are two types of options, calls and puts. A call gives the buyer the right to buy the stock at the strike price of the option anytime before it expires, while a put gives the buyer the right to sell it at that price. To earn this right, the buyer pays a premium. The premium is based on the odds of that particular option being profitable, and those odds are mostly determined by the strike price and the amount of time remaining before the option expires. The reason that there are different strike prices and dates is so each trader can choose the exact amount of risk that makes him comfortable.

As an example, a call option on SPY with a strike price of $136 that expires on April 21 might have a premium of $2.50 per share. Each option controls 100 shares of stock, so one April 21 $136 SPY call will cost a total of $250. The reason a trader would buy this option is that he is confident that the S&P 500 will rise significantly by mid-April, but might have concerns that the European debt crisis or tensions with Iran could bring prices down. If the market performs poorly, the most he can lose on the trade is $250, but he has unlimited profit as long as the share price rises at least $2.50. That means the price of SPY must rise to at least $138.50 before April 21 or there will be no profit.

Now consider another trader who thinks the market is headed for a deeper correction but does not want to be left on the sidelines if his prediction is incorrect. He might choose to buy a call with a higher strike price. With the premium of the April 21 $140 SPY calls at about $0.80, he could buy one contract for about $80, and that is his maximum loss on the trade. However, he would not realize a gain when the call expired unless the share price was above $140.80. The odds are much greater that he will lose his entire $80 than the trader who bought the $136 call, but he has a lot less capital at risk. Both traders have unlimited profit, but the buyer of the $140 call needs a much bigger price move to get to his profit.

A third type of trader would be one who is not concerned as much with the odds, because he is looking to use options as a replacement for buying the underlying stock. Such a trader would likely have found strong evidence on charts that indicated a buying opportunity. Rather than purchase 100 shares of SPY for $13,600 he could buy an April 21 $130 SPY call for $6.80 per share, or $680. The share price only needs to rise 80 cents for him to break even on the trade, and he has unlimited profit beyond that point, but he has a much greater risk of loss if his technical analysis of the charts was flawed than he would buying a call at a higher strike price.

Once a strike price has been chosen, the expiration date needs to be considered. Option premiums tend to decrease over time. This time decay increases as expiration day approaches, so options with a March expiration will have much lower premiums than those that expire in April, while those that expire in April will have only slightly lower premiums than those with May expiration.

Assuming a trader had chosen the $136 strike price, the March 17 SPY calls might have a premium of $1.50 per share, which is much less than the $2.50 premium on the April options. However, the March options will lose all of their time value by March 17, while the April options will only lose a small amount. A trader who is confident that the recent correction in the market is complete and prices will immediately resume their uptrend would be better off with a March call because of the lower premium, however he only has one week to be right or he loses $150. A trader who thought the bull market was going to continue, but not before a few more corrections, would be better off with the April call because he would have more time for his predictions to prove true. If SPY was still trading at $136 on March 17, the $136 March call would expire worthless while the $136 April call would lose some value, but probably still have a premium of about $2.00.

If a trader did choose to buy the $136 April call, he would enter an order to “buy to open” one SPY $136 April 21 call at “market price”. This does not guarantee the best price, but it is the simplest way to complete the trade. If the trader later decides to get out of the trade, he would “sell to close”. This sequence only applies to option buyers, and there are many trades that entail selling options, such as covered calls. For a covered call, the order is entered as “buy 100 shares” and “sell to open 1 call”, and ending the position is done with an order to “sell 100 shares” and “buy to close 1 call”.

These are only the basic principles of choosing the strike price and expiration date, and there are many other things to consider before trading.

See ZenTrader.ca for the entire article

Option Trading Secrets

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