Options are attractive to the private trader due to their special advantages. By buying options, you are given the opportunity to participating in the market with limited known risk. Besides, the capital that you need to invest is just a small fraction of the price of the underlying shares. Option buyer need to pay a premium when buying options, which is very much less than the stock prices.
For those who are not familiar how actually options work, it may be a little bit confusing in the beginning. Options actually share a lot of same characteristics like insurance policies, which most people should be able to understand. We will get a clearer picture of how literally options work by checking through the features that options and insurance policies have.
For an insurance policy, the policy is actually a contract between the purchaser and the underwriter of the insurance policy. Underwriter of the insurance policy is the company, whose sells the policy. Whereas; option is a contract between the option buyer and seller when there is an initial transaction taking place. Stated in the contract, option buyer has the right to buy an amount of stock from the seller at an agree price within a specific period of time; whereas, seller has to obligate to sell an amount of stock to the buyer at an agree price within a specific period of time. This agreed price is called strike price.
For insurance policy, purchaser pays a premium to the insurance underwriter. The probability payout is influenced by a number of factors, which the premium is dependent. Premium will be charged higher if the risk payout is higher. Whereas for option; purchaser of the option contract pays premium to the writer of the option. A number of factors, which will affect the overall likelihood of a particular stock price being reached, will also affect the amount that needed to be paid as a premium. When the premium for the option is higher, the likelihood of a stock price can reached also higher.
In term of time period, the validity of the insurance policy is within a specific length of time. The passing of time works in favour to the insurance underwriter but against to the purchaser of the insurance policy. For option, it works exactly same as the insurance policy, that is option contract is valid within a specific length of time. When the time passes, it does not favour to the option buyer but favour to option writer.
Upfront is the risk for the purchaser of the insurance contract. The policy is paid by the premium. The insurance underwriter risk is open-ended depending on the terms that are insured. In options trading, the options buyer risk is also known as upfront. The option is paid by the premium. Here are the differences between insurance policy and the option. The option buyer can gain more than premium that he or she has paid for the option but not less than the premium. On the other hand, option writer has open-ended risk potential, which may cause unlimited loss.
In term of payout, if there is any event that has been stated in the insurance policy has occurred, the payout from the insurance company will be a lot more than the original premium paid. If the market direction favours the option buyer, then he or she has unlimited profit potential. The option buyer may make a lot of money, which is many times more than the premium that he or she has been paid.
Alexander Chong -
Author of “Workable Option Trading Strategies”
http://www.makemoneystocks.com/
Sunday, November 30, 2008
Monday, October 13, 2008
Options trading edge
Many private traders deem that options are thought to be traded by experts with good mathematical skill. There are two reasons why many private traders think so, that are. trading options are too risky and difficult. Many private traders think that it is easier to just trade stocks or futures. So, a simple question, if trading futures or buying stocks looks so much easier and less complex to do, then why options are available to be traded? The actual reason is that options, which are unlike other trading vehicle, can offer a trading edge to the private traders and allow them to cover almost any investment strategy and risk profile with flexibility. In many ways, options are the most superior trading vehicles that many traders use nowadays. To trade options, you certainly do not need to be an expert in financing.
In the book "The New Market Wizards" written by Jack Schwager, concludes that nobody can win without an edge, even you have the world greatest discipline and money management skill. If you trade futures on the All Ordinaries Share Price Index (SPI), you have to know exactly what is your trading edge; particularly, if you are a professional floor trader. With the trading edge, you should able to see the buy and sell orders that coming into the trading pit and also who is buyer and seller. Besides, the speed of execution of your orders and the transaction costs also should able to see. The popularity of the stocks, options and futures is increasing; therefore, many people trade these products. Only a small proportion of these traders apply a real trading edge. The main reasons for the unsuccessful of many private traders in the financial markets are due to the lack of a trading edge, poor risk management and insufficient capital. The key point here is to find an edge, utilize it consistently and use the right risk and money management techniques. When the odds are in your favor, it is better that you learn how to trade options. It is also importantly when the odds are not in your favor, make sure you stand aside. You are doing yourself with the best possible chance of success if you doing so. Trading systems are as many as traders. We won't trade a system if it doesn't provide us with some sort of edge. If you have a system, which is able to give you an edge, why not further enhance your edge by trading options in a right circumstance. Before placing a trade, try to get as many factors that going in your favor as possible. By practicing this, you provide yourself with a much greater chance to success in the long run.
Without doubt, with any form of trading, there are no absolute guarantees. You can't help compared to the many of the people who do not know anything about options and trade without an edge. But, you have a better chance to succeed in the long run and reach your financial ambitions. Flexibilities that can be offered by options are as follows:
i) Profit gained from an accurately anticipating rising or falling market.
ii) With a relatively small disbursement, your potential returns can be greatly magnified.
iii) If the market goes to the way that you anticipate, you have unlimited profit potential, whilst you limit your risk by choosing an amount that you afford to risk.
iv) Profit still can be gained by correctly picking options where the market will not go.
v) Profit gained from flat or non-trending phases markets.
vi) Profit gained by letting the time passes by.
vii) Profit gained at an increasing rate when the market moves further in your favor.
Extremely flexible trading tool is option. You can use options trading strategies that are precisely suit your view of market, whilst sewing them closely to your personal risk tolerance level.
People who trade options for a living and as their business will try to understand and apply the principles, which have been outlined in this article. They do so because they know that there is an edge for then to be gained compare to the people who don't. They are similar to the typical casino gambler if they do not trade with edge; their money will be destined to be lost ultimately. They are exactly like the casino itself if they trade with trading edge. For those people who trade the markets to make their living, you probably don't have the chance to talk with them. Their occupation looks exotic and these people are imagined as weird mathematical geniuses who could give their money to Kasparov to run it in a chess tournament. The flair of occupational options traders couldn't be going beyond from the veracity. Although many of the professional options traders who involve in the financial markets are intelligent people, they were not in the genius category. Nevertheless, they have one thing in common among them. They knew and applied certain unique principles in their options trading. The principles that they utilized offered then an edge to successfully trading in the market. Therefore, throughout their options trading life, they earn a good living.
You don't have to be a professional options trader. The edge offered from the principles to the professional options traders also available to the private traders as well. Practically, these principles can be learnt and applied by yourself and the odds can be helped to put it more squarely in your favor. All the advantages that most of the professional options traders have may not be possessed by you. By using the same principles that they used, you can learn to make your trading more selective. In this way, you too can benefit from a trading edge.
Alexander Chong -
Author of “Workable Option Trading Strategies”
http://www.makemoneystocks.com/
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In the book "The New Market Wizards" written by Jack Schwager, concludes that nobody can win without an edge, even you have the world greatest discipline and money management skill. If you trade futures on the All Ordinaries Share Price Index (SPI), you have to know exactly what is your trading edge; particularly, if you are a professional floor trader. With the trading edge, you should able to see the buy and sell orders that coming into the trading pit and also who is buyer and seller. Besides, the speed of execution of your orders and the transaction costs also should able to see. The popularity of the stocks, options and futures is increasing; therefore, many people trade these products. Only a small proportion of these traders apply a real trading edge. The main reasons for the unsuccessful of many private traders in the financial markets are due to the lack of a trading edge, poor risk management and insufficient capital. The key point here is to find an edge, utilize it consistently and use the right risk and money management techniques. When the odds are in your favor, it is better that you learn how to trade options. It is also importantly when the odds are not in your favor, make sure you stand aside. You are doing yourself with the best possible chance of success if you doing so. Trading systems are as many as traders. We won't trade a system if it doesn't provide us with some sort of edge. If you have a system, which is able to give you an edge, why not further enhance your edge by trading options in a right circumstance. Before placing a trade, try to get as many factors that going in your favor as possible. By practicing this, you provide yourself with a much greater chance to success in the long run.
Without doubt, with any form of trading, there are no absolute guarantees. You can't help compared to the many of the people who do not know anything about options and trade without an edge. But, you have a better chance to succeed in the long run and reach your financial ambitions. Flexibilities that can be offered by options are as follows:
i) Profit gained from an accurately anticipating rising or falling market.
ii) With a relatively small disbursement, your potential returns can be greatly magnified.
iii) If the market goes to the way that you anticipate, you have unlimited profit potential, whilst you limit your risk by choosing an amount that you afford to risk.
iv) Profit still can be gained by correctly picking options where the market will not go.
v) Profit gained from flat or non-trending phases markets.
vi) Profit gained by letting the time passes by.
vii) Profit gained at an increasing rate when the market moves further in your favor.
Extremely flexible trading tool is option. You can use options trading strategies that are precisely suit your view of market, whilst sewing them closely to your personal risk tolerance level.
People who trade options for a living and as their business will try to understand and apply the principles, which have been outlined in this article. They do so because they know that there is an edge for then to be gained compare to the people who don't. They are similar to the typical casino gambler if they do not trade with edge; their money will be destined to be lost ultimately. They are exactly like the casino itself if they trade with trading edge. For those people who trade the markets to make their living, you probably don't have the chance to talk with them. Their occupation looks exotic and these people are imagined as weird mathematical geniuses who could give their money to Kasparov to run it in a chess tournament. The flair of occupational options traders couldn't be going beyond from the veracity. Although many of the professional options traders who involve in the financial markets are intelligent people, they were not in the genius category. Nevertheless, they have one thing in common among them. They knew and applied certain unique principles in their options trading. The principles that they utilized offered then an edge to successfully trading in the market. Therefore, throughout their options trading life, they earn a good living.
You don't have to be a professional options trader. The edge offered from the principles to the professional options traders also available to the private traders as well. Practically, these principles can be learnt and applied by yourself and the odds can be helped to put it more squarely in your favor. All the advantages that most of the professional options traders have may not be possessed by you. By using the same principles that they used, you can learn to make your trading more selective. In this way, you too can benefit from a trading edge.
Alexander Chong -
Author of “Workable Option Trading Strategies”
http://www.makemoneystocks.com/
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Tuesday, January 23, 2007
Call and Put Option: Option Trading Basic Fundamental Theory
It is very common that stock is transacted in blocks divisible by 100, which is called a round lot. A round lot has become a standard trading unit on the public exchanges for quite sometime ago. In stock market, we have the right to buy and sell an unlimited number of shares as long as there are people are willing to sell and we are willing to buy at the price that the seller has fixed. Usually, for a brokerage firm, they set their commission for a transaction for minimum 100 units of share at a certain price. If we buy less than 100 units of share, they still impose us this commission. For an example, if we buy 100 units share and pay the brokerage firm USD 30 for the buy and sell transactions, they also charge us that amount: USD 30 also, if we only buy and sell 1 units of share. The amount of commission that the brokerage firm charges for the stock transaction is varied from one and other. Some brokerage firm may charge less but they require you to trade a lot in one transaction. So, each unit of option is representing 100 units of share.
In fact, there are two types of options that are call and put option. Call option gives its owner the right to buy 100 units of share of a company at a specified price that has been agreed between the call option owner and the seller within certain period of time. So, within this period of time, if the stock price goes up, the call option price will also go up and vice versa. The second type of option is put option. This option gives its owner the right to sell 100 units of share of a company at a specified price that has been agreed between the put option owner and the seller within certain period of time. Put option seems like the opposite of call option. If the stock price goes up within this period of time, the put option price will go down. Either call or put option can be bought or sold. As long as there are people willing to sell, there will be people willing to buy. There are four permutations that are possible exist during the transaction of an option. The first one is buying a call option meaning that buy the right for yourself to buy 100 units of share. Second is selling call option meaning that sell the right to buy 100 units share from you to someone else. The third one is buying a put option meaning that buy the right for yourself to sell 100 units of shares. The last one is selling a put option meaning that sell the right to sell 100 units of share to you to someone else.
The other way to make these differences clearer is always remember that the call option buyer hopes the stock price will go up and the put option buyer looking for the price per share to fall. For the opposite side, a call option seller is hoping the stock price will maintain or fall. Whereas, put option seller is hoping that the stock price will go up. If the option buyer no matter dealing with the calls or puts option is correctly predicting the price movement of the stock, then they will gain profit from their action. For option, there is another obstacle we have to face besides estimating the direction of the stock price movement. This obstacle is that the change of the stock price has to be taken place before the deadline of the option. As a stockholder, we may be able to predict a stock’s long-term prospects by waiting for a long-term change of the stock. However, for option holder, we may not have that kind of opportunity. This is because options are finite; they will lose all their value within a short period of time, usually within a few months. However, it has long-term options that can last up to one to three years. Due to this limitation, time will be an important factor to determine whether an option buyer can earn a profit or not.
Foremost, option is granting the buyer an intangible right to buy or sell 100 units of share at an agreed price between the buyer and seller of the option. Therefore, option is just an agreement regarding to 100 units of share of a specific stock and to a specific price per share. Therefore, if the buyer buys an option at the wrong timing, then, the buyer will not able to make any profit. Wrong timing means that the stock price does not move or does not move substantially when the deadline has arrived. When we buy a call option, it seems like we are agreeing that we are willing to pay the price that being asked to acquire a contractual right. The right provided that we may buy 100 units of share of stock at a specified fixed price per share, and this right exists at the time we purchased the option until the deadline of the option. Within the time we purchased the option until the deadline of the option, if the stock price goes up more than the fixed price indicated in the option agreement, this call option will become more valuable. Just think that we buy a call option that granting us the right to buy 100 units of shares at the price of USD 70 per share. Let said before the option deadline, the stock price has gone up to USD 90 per share. As an owner of this call option, we have the right to buy 100 units of share at USD 70, which is USD 20 less than the current market price. This is the situation when stock market price is more than the fixed contractual price indicated in the call option contract. In this example, we as buyer would have the right to buy 100 units share, which is USD 20 less than current market price. Although we own the right to do so, we may unnecessarily to execute our right. For an example, how about if the stock price has gone down to USD 50. We would not have to buy shares at the fixed price of USD 70 and we could select not to take any action.
Alexander Chong
Author of “Workable Option Trading Strategies”
http://www.makemoneystocks.com/
In fact, there are two types of options that are call and put option. Call option gives its owner the right to buy 100 units of share of a company at a specified price that has been agreed between the call option owner and the seller within certain period of time. So, within this period of time, if the stock price goes up, the call option price will also go up and vice versa. The second type of option is put option. This option gives its owner the right to sell 100 units of share of a company at a specified price that has been agreed between the put option owner and the seller within certain period of time. Put option seems like the opposite of call option. If the stock price goes up within this period of time, the put option price will go down. Either call or put option can be bought or sold. As long as there are people willing to sell, there will be people willing to buy. There are four permutations that are possible exist during the transaction of an option. The first one is buying a call option meaning that buy the right for yourself to buy 100 units of share. Second is selling call option meaning that sell the right to buy 100 units share from you to someone else. The third one is buying a put option meaning that buy the right for yourself to sell 100 units of shares. The last one is selling a put option meaning that sell the right to sell 100 units of share to you to someone else.
The other way to make these differences clearer is always remember that the call option buyer hopes the stock price will go up and the put option buyer looking for the price per share to fall. For the opposite side, a call option seller is hoping the stock price will maintain or fall. Whereas, put option seller is hoping that the stock price will go up. If the option buyer no matter dealing with the calls or puts option is correctly predicting the price movement of the stock, then they will gain profit from their action. For option, there is another obstacle we have to face besides estimating the direction of the stock price movement. This obstacle is that the change of the stock price has to be taken place before the deadline of the option. As a stockholder, we may be able to predict a stock’s long-term prospects by waiting for a long-term change of the stock. However, for option holder, we may not have that kind of opportunity. This is because options are finite; they will lose all their value within a short period of time, usually within a few months. However, it has long-term options that can last up to one to three years. Due to this limitation, time will be an important factor to determine whether an option buyer can earn a profit or not.
Foremost, option is granting the buyer an intangible right to buy or sell 100 units of share at an agreed price between the buyer and seller of the option. Therefore, option is just an agreement regarding to 100 units of share of a specific stock and to a specific price per share. Therefore, if the buyer buys an option at the wrong timing, then, the buyer will not able to make any profit. Wrong timing means that the stock price does not move or does not move substantially when the deadline has arrived. When we buy a call option, it seems like we are agreeing that we are willing to pay the price that being asked to acquire a contractual right. The right provided that we may buy 100 units of share of stock at a specified fixed price per share, and this right exists at the time we purchased the option until the deadline of the option. Within the time we purchased the option until the deadline of the option, if the stock price goes up more than the fixed price indicated in the option agreement, this call option will become more valuable. Just think that we buy a call option that granting us the right to buy 100 units of shares at the price of USD 70 per share. Let said before the option deadline, the stock price has gone up to USD 90 per share. As an owner of this call option, we have the right to buy 100 units of share at USD 70, which is USD 20 less than the current market price. This is the situation when stock market price is more than the fixed contractual price indicated in the call option contract. In this example, we as buyer would have the right to buy 100 units share, which is USD 20 less than current market price. Although we own the right to do so, we may unnecessarily to execute our right. For an example, how about if the stock price has gone down to USD 50. We would not have to buy shares at the fixed price of USD 70 and we could select not to take any action.
Alexander Chong
Author of “Workable Option Trading Strategies”
http://www.makemoneystocks.com/
Stock, Bond and Option
We may not familiar with option but we are sure that most of us know what is stock and bond. Stock is an equity that representing a company value. By purchasing stock, you are actually buying the ownership of a public listed company, which means that you are one of the owners of the company. There are many purposes to purchase stocks. It can for long term investment, short term investment, really intending to own a company or speculation for very short term investment. No matter what is their purpose, usually, they will buy large amount of stock. Especially, for them who want to control the administration of a public listed company. This kind of investor will buy as many stocks as possible in order that they have a majority stock in their hand. In this kind of situation, he or she has the control power to the company administration and can do some modification to the processing and also the management of the company. By owning an amount of stock, you will be paid dividend if the company has declared it. Some company may not pay you any dividend depending to the company highest management decision. Some company may let you vote in their company election such electing a suitable CEO or MD. When you own a stock, you have the total control of this stock. You can sell it anytime if you think that you no longer intended to own it or you think that it is not worth to own it. You can also keep it for your whole life and use it as collateral to borrow money from bank or financial institution.
Bond is a debt that the bond issuer own you if you have bought the bond. When there is a project to carry out regardless it is a big or small project, if the people who intend to start the project do not have money, one of the sources for them to generate fund is by printing bond and selling it to public. By doing this, they can generate fund to carried out the project. This seem like the owner of the project borrows money from you and they give you the bond as evidence that they have borrowed money from you. By owning this bond, you will be paid interest and repaid all the money that you have lent to them at a specific date. Not anybody can print bond and sell it to public. People who want to do so have to apply to the government as a bond issuer. Usually, these people are from corporate agency, states, cities and federal government agency. As a bond holder, you have priority to have your money back compared to shareholder if the bond issuer goes broke. They will pay back the money for you as a bond holder before they pay to their shareholder.
Stock and bond have a tangible value that you can grasp and visualize. The ownership of a stock that you have purchased can last for a long time as long as you continue hold this stock and don’t sell it. The ownership of a stock can not be canceled unless the company goes broke (means that the company have declared bankruptcy). Bond usually has contract type repayment schedule and once they have paid back all the money that you have lent to them, the bond will end. The third type of investment does not give a whole life ownership and does not provide any tangible value. The validity of this investment has expiration date. Once the expiration date has over, the whole investment will become worthless. Apart from that, the value of this investment will decline when the time passes by. These are part of the features that options have. Due the lack of tangible value, worthlessness after expiration date and value declines due to the time has passed by; all these make options seem too risky to be invested for most of the people. However, there are still a lot of investors interested in option investment. Do you know why?
This is because not all methods that had been used in trading option are risky. What had been mentioned just now such as lack of tangible value, worthless after expiration date and option value declines after the time had passed by can work to our advantage. For an example, we can sell option that has a very short period of time to expiration date, which has a low possibility to become in the money option. Like this, when the time has passed by, option value that has declined will be our gain. There are limited strategies to trade stock but for option, there are a lot of strategies can be utilized. For stock, we either buy or sell stock. That’s all what we can do. But for option, we can combine a few positions together to form a synthetic position to earn money from the stock that move either up, down or side way. You will realize that options are very flexible after you have study more about it. You can use options in numerous situations and create numerous opportunities.
An option is a contract of agreement that allows you have a privilege in executing transaction involving 100 units of stock. This agreement only involves the option buyer and seller. This privilege includes a specific stock with a specific fixed price per share and also a specific date in the future for its validity. When we have bought a contract of option, we do not have any equity in the stock and any debt position. What we have is a contractual right to buy and sell 100 units of share at a fixed price within a fixed period of time. You will feel wondering why we need to purchase an option to gain the right since we can always buy or sell 100 units of share at the current market price. The answer is that option has fixed the stock price that you can buy or sell and this is the key to an option’s value. Stock price is unpredictable and this feature makes stock market investment interesting and also very risky. When we own an option, the stock price that we can sell and buy 100 units share is already frozen for as long as the option remains valid. Finally, the option’s value is determined by the comparison of the fixed price and the stock market current price.
Alexander Chong
Author of “Workable Option Trading Strategies”
http://www.makemoneystocks.com/
Bond is a debt that the bond issuer own you if you have bought the bond. When there is a project to carry out regardless it is a big or small project, if the people who intend to start the project do not have money, one of the sources for them to generate fund is by printing bond and selling it to public. By doing this, they can generate fund to carried out the project. This seem like the owner of the project borrows money from you and they give you the bond as evidence that they have borrowed money from you. By owning this bond, you will be paid interest and repaid all the money that you have lent to them at a specific date. Not anybody can print bond and sell it to public. People who want to do so have to apply to the government as a bond issuer. Usually, these people are from corporate agency, states, cities and federal government agency. As a bond holder, you have priority to have your money back compared to shareholder if the bond issuer goes broke. They will pay back the money for you as a bond holder before they pay to their shareholder.
Stock and bond have a tangible value that you can grasp and visualize. The ownership of a stock that you have purchased can last for a long time as long as you continue hold this stock and don’t sell it. The ownership of a stock can not be canceled unless the company goes broke (means that the company have declared bankruptcy). Bond usually has contract type repayment schedule and once they have paid back all the money that you have lent to them, the bond will end. The third type of investment does not give a whole life ownership and does not provide any tangible value. The validity of this investment has expiration date. Once the expiration date has over, the whole investment will become worthless. Apart from that, the value of this investment will decline when the time passes by. These are part of the features that options have. Due the lack of tangible value, worthlessness after expiration date and value declines due to the time has passed by; all these make options seem too risky to be invested for most of the people. However, there are still a lot of investors interested in option investment. Do you know why?
This is because not all methods that had been used in trading option are risky. What had been mentioned just now such as lack of tangible value, worthless after expiration date and option value declines after the time had passed by can work to our advantage. For an example, we can sell option that has a very short period of time to expiration date, which has a low possibility to become in the money option. Like this, when the time has passed by, option value that has declined will be our gain. There are limited strategies to trade stock but for option, there are a lot of strategies can be utilized. For stock, we either buy or sell stock. That’s all what we can do. But for option, we can combine a few positions together to form a synthetic position to earn money from the stock that move either up, down or side way. You will realize that options are very flexible after you have study more about it. You can use options in numerous situations and create numerous opportunities.
An option is a contract of agreement that allows you have a privilege in executing transaction involving 100 units of stock. This agreement only involves the option buyer and seller. This privilege includes a specific stock with a specific fixed price per share and also a specific date in the future for its validity. When we have bought a contract of option, we do not have any equity in the stock and any debt position. What we have is a contractual right to buy and sell 100 units of share at a fixed price within a fixed period of time. You will feel wondering why we need to purchase an option to gain the right since we can always buy or sell 100 units of share at the current market price. The answer is that option has fixed the stock price that you can buy or sell and this is the key to an option’s value. Stock price is unpredictable and this feature makes stock market investment interesting and also very risky. When we own an option, the stock price that we can sell and buy 100 units share is already frozen for as long as the option remains valid. Finally, the option’s value is determined by the comparison of the fixed price and the stock market current price.
Alexander Chong
Author of “Workable Option Trading Strategies”
http://www.makemoneystocks.com/
Wednesday, December 13, 2006
Option Trading Strategy: Back spread
Option is a very popular derivative because its price is cheaper than other derivative such as future. Blue chip stock is a very volatile stock but it is very expensive. However, by buying option of the blue chip stock, we could earn profit just similarly like buying the stock. Investing and trading option seem to be very easy just like buying stock. However, due to the existence of time value and also the expiration date of the option, buying naked option is very risky. This is because if the stock price is going down a lot just after you have bought the naked option, after a certain period of time, although the stock price has gone up, the option price may still below the ask price that you have used to buy this option. That why we need strategy to invest or trade option. Option is a very powerful tool in investing and trading stock. By utilizing option, we could earn profit from the stock that moves upside, downside and sideway. Moreover, option also could be used to execute arbitrage strategy to earn a profit no matter the stock price is going up, down or sideway.
Back spread is one of the option trading strategies that is quite popular. This strategy is quite similar to a Chinese gambling called big and small. In this gambling, when we stake big and the three dices after shook and opened show the total point is big, we will win one fold of the money that we have staked. That means if we stake 100, we will get back one more 100. But if we loss, we will loss 100. Back spread strategy is quite similar to this gambling game. That means if we invest USD 1000, we either get back one more USD 1000 or loss USD 1000 that has been staked in. The maximum profit and loss is USD 1000. That has fixed. You won’t loss more that that. Actually, back spread is the reversal of the ordinary spread. The maximum profit and loss is not always the same. Sometimes, it will differ a little bit and depend to current price of the stock.
This strategy could be executed by buying out-of-the-money option and selling in-the-money option. Because the price of the in-the-money option is more than out-of-the-money option, the amount of money that has been received after selling in-the-money option will be enough to buy the out-of-the-money option. Although like this, we still need to put an amount of deposit in our trading account and the amount usually is equivalent to the maximum loss that you could incur if the stock price goes to the reverse direction. So, if we are expecting the stock price will go up in the near future, we should buy out-of-the-money and in-the-money put option. Conversely, if we are expecting the stock price will go down in the near future, we should buy out-of-the-money and in-the-money call option. Just for easy to understand, we try an example. Table below shows a list of put options for MMM company stock, which will expire in Apr 07.
http://www.makemoneystocks.com/back-spread-table1.jpg
Table 1: List of put options for MMM company stock.
Current price of the stock is USD 80.94. Put option with its strike price more than current price is in-the-money option and less than current price is out-of-the-money option. If we are expecting the stock price will go up in the near future, we will buy one contract of 80 put option (MMMPP) and sell one contract of 85 put option (MNZPQ). When we sell option, we will receive an amount of money that is equivalent to the bid price multiplying with the number of unit that has been purchased. The amount of money that has been received per unit option is USD 5.2 and the amount of money that we need to pay per unit option when we buy out-of-the-money option is USD 2.7. Therefore, the net amount in your trading account after executing this strategy is USD 2.5 per unit option. That means there will be USD 250 net in your trading account. The maximum profit and loss are calculated as follow:
Maximum profit = In-the-money option bid price – Out-of-the-money option ask price
Maximum loss = (upper level strike price – lower level strike price) – (In-the-money option bid price – Out-of-the-money option ask price)
Upper level strike price is 85 and lower level strike price is 80. In-the-money option bid price is USD 5.2 and the out-of-the-money ask price is USD 2.7. After substituting all values into the equations above, we will know that the maximum profit is USD 2.5 and the maximum loss is also USD 2.5. So, if we buy one contracts each of the in-the-money and out-of-the-money option, the maximum profit is USD 250 and the maximum loss is also USD 250. The breakeven point for this strategy could be calculated using equation as follow:
Breakeven point = Upper level strike price – maximum profit
Or Breakeven point = Lower level strike price + maximum loss.
In this case, the breakeven point is 82.5. As long as the stock price goes up more than 82.5, we will earn a profit from this strategy. We only could earn the maximum profit if we keep the position until the expiration date. If we sell off early before the expiration date, we could not earn the maximum profit. But we still can earn money but with a little bit lesser than if we could keep the position until the expiration date. This is due to the incomplete gaining of the time value of the sell off in-the-money option.
So, by utilizing this option trading strategy, you could earn a profit as long as your prediction accuracy is more than 50 %. That means you have to be accurate for at least six bets within ten bets. From here, the maximum continuous loss is four times. Therefore, in order that you won’t lose all your money until you could not continue to bet, you have to keep four back up moneys or more. So, if you lose one bet, you still have the money to continuously stake for the following bet. Like this, as long as you could keep your prediction accuracy more than 50 %, your money will continuously grow along the time. So, if you interested to know more about option trading strategy, just drop by our homepage and we will show you how to utilize option to maximize your profit.
Alexander Chong
Author of “Workable Option Trading Strategies”
http://www.makemoneystocks.com/
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Tuesday, November 21, 2006
How to make money in the stock market
There are abundant of money in the stock market. However, not everybody can get the money out from there. Some people can gain a lot from the stock market but some has lost a lot of money there. It is very indecisive. Sometime at that moment, you loss money but after a few days, you may earn a profit and sometime is reverse. So, how should we do to get the money out from the stock market? Usually, there are two ways to get the money out from the stock market; that are investing and trading. The difference between trading and investing is trading involves buying and selling share, future or option within a short period of time; whereas investing is buying share, future or option and hold it for quite a long time, usually one year or more before selling it.
What is the difference between share, future and option? What we know is that option is much cheaper than the share and future, usually is tenfold lesser than the share price. So, if you have an amount of money that enough for you to buy 100 units share, you can use that amount of money to buy 1000 units option. And the return of investment is almost the same between share and option. Therefore, you will earn around tenfold if you buy option rather than share or future. However, the disadvantage is that if you lose on that trade, you will lose almost tenfold also. When we trade option, the amount of money that we can profit and lose is almost same as if we trade share. However, we need a lot of money to buy share compared to buy option. This causes the percentage of the profit and loss for buying option is much higher than share. The example is like when you buy $10 for one unit of share and $1 for one unit of option. When the share price drops for $0.10, the percent drop for buying share is 1% but for buying option, the percent loss is 10%. That’s why the percentage of the profit and loss for buying option is huge compared to buying share even though the share price fluctuates in a small amount.
Due to the high profit and loss when buying option, trading or investing option is just like gambling. It is quite normal that the return of investment is more than 100%. But it is also quite normal that you could lose all your money in the investment or trading. In order that you can earn more than lose, you need to know some basic option trading strategy and technical analysis. Option is different from the share. Option has time value; whereas, share does not have time value. The value of one share will not depreciate due to the passage of the time. It is only affected by the supply and demand and also the company performance. However, option value will depreciate when the time has passed. When the time reaches to the option expiration date, there is no more time value for that option. That’s why, you need to use strategy to trade option, in order that you can minimize the loss and maximize the profit.
The very basic two option trading strategies are bullish call spread and bearish put spread. Bullish call spread is used when the stock price is anticipated to rise in the coming months; while, bearish put spread is used when the stock price is anticipated to drop in the coming months. Steps that are involved in this strategy are buying in the money option and selling out of the money option. In the money option is the option that has time value and intrinsic value; whereas, out of the money option only has time value. When the stock price moves to the positive side (generated money side), in the money option will generate profit and the out of the money option will cause loss. However, the minus of the profit and the loss is the net profit that has generated from this strategy. When the stock price moves over the out of the money strike price, the profit will become maximized. Continuously moving of the stock price to the positive side will not generate any profit. In this situation, we will close both positions to take the profit out from the market.
If the stock price moves to negative side (opposite side that cause loss), in the money option’s value will depreciate and the out of the money option will generate profit. However, the profit, which is generated from the out of the money, is limited to the price that you have sold. The subtraction between out of the money’s profit and in the money’s loss is a negative value. This is because the profit that is generated from the out of the money option is less than the loss that is caused by in the money option. Out of the money option’s profit is limited in this strategy and in the money option’s loss is unlimited. If the stock price continuously moves to the negative side, you may lose all of your capital. So, what is the difference from buying naked option and buying option using spread strategy? The difference is that you may lose more money if you buy naked option and lose less money if you buy spread. This is because you do not generate any profit when you just buy naked option; whereas, profit is generated from the out of the money option if the stock price moves to the negative side. The disadvantage of the spread is that the commission, which is charged by the broker firm, is double compared to the naked option. This is because, naked option only involves one position; whereas, spread involves two positions. Each position will be charged with commission separately.
Besides, the purpose of selling out of the money option in the spread strategy is to minimize the loss of the time value of the in the money option. Actually, both in and out the money option’s time value would depreciate when the time has passed. Because we do not own the out of the money option; therefore, we can keep the money that we have received from selling that option. When the time value of this out of the money option has depreciated, we used lower price to buy back the option. So, we sell at high price and buy back at low price; therefore, we earn money. The money that we have earned usually is enough to cover the loss of the time value from the in the money option. However, you still lose the intrinsic value of option if the stock price moves to the negative direction.
So, bullish call and bearish put spreads are two of the very basic option trading strategies. However, it is not guaranteed 100 % win from the stock market. You still need to learn to predict the stock price direction accurately using technical, fundamental and news analysis.
What is the difference between share, future and option? What we know is that option is much cheaper than the share and future, usually is tenfold lesser than the share price. So, if you have an amount of money that enough for you to buy 100 units share, you can use that amount of money to buy 1000 units option. And the return of investment is almost the same between share and option. Therefore, you will earn around tenfold if you buy option rather than share or future. However, the disadvantage is that if you lose on that trade, you will lose almost tenfold also. When we trade option, the amount of money that we can profit and lose is almost same as if we trade share. However, we need a lot of money to buy share compared to buy option. This causes the percentage of the profit and loss for buying option is much higher than share. The example is like when you buy $10 for one unit of share and $1 for one unit of option. When the share price drops for $0.10, the percent drop for buying share is 1% but for buying option, the percent loss is 10%. That’s why the percentage of the profit and loss for buying option is huge compared to buying share even though the share price fluctuates in a small amount.
Due to the high profit and loss when buying option, trading or investing option is just like gambling. It is quite normal that the return of investment is more than 100%. But it is also quite normal that you could lose all your money in the investment or trading. In order that you can earn more than lose, you need to know some basic option trading strategy and technical analysis. Option is different from the share. Option has time value; whereas, share does not have time value. The value of one share will not depreciate due to the passage of the time. It is only affected by the supply and demand and also the company performance. However, option value will depreciate when the time has passed. When the time reaches to the option expiration date, there is no more time value for that option. That’s why, you need to use strategy to trade option, in order that you can minimize the loss and maximize the profit.
The very basic two option trading strategies are bullish call spread and bearish put spread. Bullish call spread is used when the stock price is anticipated to rise in the coming months; while, bearish put spread is used when the stock price is anticipated to drop in the coming months. Steps that are involved in this strategy are buying in the money option and selling out of the money option. In the money option is the option that has time value and intrinsic value; whereas, out of the money option only has time value. When the stock price moves to the positive side (generated money side), in the money option will generate profit and the out of the money option will cause loss. However, the minus of the profit and the loss is the net profit that has generated from this strategy. When the stock price moves over the out of the money strike price, the profit will become maximized. Continuously moving of the stock price to the positive side will not generate any profit. In this situation, we will close both positions to take the profit out from the market.
If the stock price moves to negative side (opposite side that cause loss), in the money option’s value will depreciate and the out of the money option will generate profit. However, the profit, which is generated from the out of the money, is limited to the price that you have sold. The subtraction between out of the money’s profit and in the money’s loss is a negative value. This is because the profit that is generated from the out of the money option is less than the loss that is caused by in the money option. Out of the money option’s profit is limited in this strategy and in the money option’s loss is unlimited. If the stock price continuously moves to the negative side, you may lose all of your capital. So, what is the difference from buying naked option and buying option using spread strategy? The difference is that you may lose more money if you buy naked option and lose less money if you buy spread. This is because you do not generate any profit when you just buy naked option; whereas, profit is generated from the out of the money option if the stock price moves to the negative side. The disadvantage of the spread is that the commission, which is charged by the broker firm, is double compared to the naked option. This is because, naked option only involves one position; whereas, spread involves two positions. Each position will be charged with commission separately.
Besides, the purpose of selling out of the money option in the spread strategy is to minimize the loss of the time value of the in the money option. Actually, both in and out the money option’s time value would depreciate when the time has passed. Because we do not own the out of the money option; therefore, we can keep the money that we have received from selling that option. When the time value of this out of the money option has depreciated, we used lower price to buy back the option. So, we sell at high price and buy back at low price; therefore, we earn money. The money that we have earned usually is enough to cover the loss of the time value from the in the money option. However, you still lose the intrinsic value of option if the stock price moves to the negative direction.
So, bullish call and bearish put spreads are two of the very basic option trading strategies. However, it is not guaranteed 100 % win from the stock market. You still need to learn to predict the stock price direction accurately using technical, fundamental and news analysis.
Alexander Chong
Author of “Workable Option Trading Strategies”
Trading Options
Option is a legal agreement between buyer and seller to buy or sell security at an agreed price in a certain period of time. It is quite similar to insurance that you pay an amount of money in order that your property is protected by the insurance company. The difference between these two is option can be traded whereas, insurance portfolio cannot be traded. There are two types of option contracts; call options and put options. We buy call option when we expect the security price will go up and buy put option when we expect the security price will go down. We also can sell call option if we expect the security price will go down and vice versa if we sell put option. Usually, option is counted by contract, one contract equivalent to 100 unit options. 1 unit option protects 1 unit share. So, one contract protects 100 unit shares.
Before learning how to trade option, terminologies that you need to know are as follow:
a) Strike price: Strike price is the price that is agreed by both buyer and seller of the option to deal with. That means if the strike price of the call option is 35, seller of this option obligates to sell security at this price to the buyer of this option even though the market price of the security is higher than 35 if the buyer exercises the option. Buyer of this option can buy a security with a price that is lower than the market price. If the current market price is $39, the buyer will earn $4. If the security price is lower than the strike price, buyer will hold the option and leave the option to expire worthless. For put option strike price, buyer of the option has the right to sell the security at the strike price to the seller of the option. That means if the put option strike price is 30, seller of this option obligates to buy the security at this price from the buyer if he or she exercises the option even though the market price is lower than this price. If the market is $25, the option buyer will earn $5. It looks like a lot of transactions have been involved; but actually, seller of the option will not buy a security and sell it to the buyer. The broker firm will do all the transaction but the extra money that has used to buy the security has to be paid by the seller. This means, if the seller loss $4, the buyer will earn $4.
b) Out of the money, in the money and near/at the money option: Option price comprises of time value and intrinsic price.
Time Value + Intrinsic Value = Option Price
Time value is the amount of money that the option worth due to the time the option has until its expiration date. Longer the time the option has until its expiration date, higher the time value of this option. Time value of an option will become zero if the option has expired. Intrinsic value for in the money call option is the difference between current market security price and option strike price. Conversely, in the money put option’s intrinsic value is the difference between option strike price and current market security price. If the current security price is lower than the call option strike price, this option is an out of the money option. It only has time value. Call option with strike price that is lower than the current market security price is an in the money option. This option has time value and also intrinsic value. Near or at the money option is the option, which strike price is close to the current market security price.
c) Delta value: Delta value shows the amount of the option price will change when the security price changes by $1.00. It is a positive value for call option and negative value for put option. It ranges from 0.1 to 1.0. Delta value for in the money option is more than 0.5 and out of the money option is less than 0.5. Delta value for deep in the money option usually is more than 0.9. If the option delta value is 0.6, meaning that when the security price goes up $1, option price will go up $0.60. If the security price goes up $0.10, the option price will goes up $0.06. Usually, $0.06 will round up to $0.10.
d) Theta value: Theta value is a negative value, which shows the decay of the option time value. Option, which has longer time to expiry, has lower absolute theta value than option, which has shorter time to expiry. High absolute theta value means the option time value decays more than the low absolute theta value option. A theta value of -0.0188 means that the option will lose $0.0188 in its premium after passage of seven days. Options with a low absolute theta value are more preferable for purchase than those with high absolute theta value.
e) Gamma value: Gamma value shows the change of the delta value of an option when the security price increases or decreases. For an example, gamma value of 0.03 indicates that the delta value of this option will increase 0.03 when the security price goes up $1. Option, which has longer time to expiry, has lower value of gamma than option, which has shorter time to expiry. The gamma value also changes significantly when the security price moves near the option strike price.
f) Vega value: Vega value shows the change of the value of option for one percent increase in implied volatility. This value is always positive. Near the money option has higher vega value compared to in the money and out of the money option. Option, which has longer time to expiry, has higher vega value than the option, which has shorter time to expiry. Since vega value measures the sensitivity of the option to the change of the security volatility, higher vega value options are more preferable for purchase than those with low vega value.
g) Implied volatility: Implied volatility is a theoretical value, which is used to represent the volatility of a security price. It is calculated by substituting actual option price, security price, option strike price and the option expiration date into the Black-Scholes equation. Options with a high volatility stocks are cost more than those with low volatility. This is because high volatility stock option has a greater chance to become in the money option before its expiration date. Most purchasers prefer high volatility stock options than the low volatility stock options.
Actually, there are twenty-one option trading strategies, which most of the option investors and traders use in their daily trading. However, I’m only introducing ten strategies as follow:
a) Naked call or put
b) Call or put spread
c) Straddle
d) Strangle
e) Covered call
f) Collar
g) Condor
h) Combo
i) Butterfly spread
j) Calender spread
Naked call and put meaning buy call and put option only at the strike price, which is close to the market security price. When the security price goes up, the profit is the subtracting of the security price to the strike price if you buy call and the reverse if you buy put.
Call and put spread is established by buying in the money or near the money option and selling out of the money option. When the security price goes up, in the money call option that you buy will generate profit and the out of the money option that you sell will loss money. However, due to the difference of the delta value, when the security price goes up, in the money call option price goes up with a higher rate compared to the out of the money call option. When you deduce the profit from the loss, you still earn money. The purpose of selling the out of the money option is to protect the depreciation of time value of in the money call option, if the security price goes down. However, if the security price continuously goes down, this will cause an unlimited loss. Therefore, stop loss has to be set at certain level. This strategy also has a maximum profit that is when security price has crossed over in the money option strike price.
Straddle can earn money no matter the security price goes up or down. This strategy is established by buying near the money call and put option at the same strike price. The disadvantage of this strategy is the high breakeven level. The sum of the call and put option ask price is the breakeven level of this strategy. You only generate profit when the security price has gone up or down more than the breakeven level. If the security price fluctuates within the upside and downside breakeven level, you still loss money. The money that you loss is due to the depreciation of the option time value. This strategy is usually applied for the security, which has high volatility or before the release of the earning report. The maximum loss of this strategy is the total amount of call and put option price. This strategy can generate unlimited profit at either side of the market direction
Strangle is quite similar to straddle. The difference is strangle is established by buying out of the money call and put option. Because both the options are out of the money option, therefore, both options have different strike. The maximum loss of this strategy is less than the straddle strategy, but difference between the upside and downside breakeven level is slightly higher than the straddle strategy. For this strategy, the upside breakeven is calculated by adding the total call and put option prices to the call option strike price. While, the downside breakeven level is calculated by subtracting the put option strike price with the total call and put option prices. The difference between the strike prices usually is about 2.50 or 5 depending to which stock that you select to buy with this strategy. If the security price fluctuates within the upside and downside breakeven level, you still loss the money due to the loss of the option time value. Application of this strategy is the same as the straddle strategy.
Covered call is established by buying a security at the current market ask price and selling out of the money call option. Selling out of the money option has limited the profit that generated from this strategy. If security price continuously goes down, it will cause an unlimited loss. Therefore, stop loss must be set. When the option has comes to its expiry, if the security price is not moving up significantly, you still earn the total option premium that you have received. If the security price goes up, sure you will earn a limited profit. If the stock price continuously goes down, it will cause an unlimited loss. Therefore, stop loss must be set. Usually, stop loss is set at the security ask price after subtracting by the option bid price. If this security price goes down and passes over the price that you set as stop loss, the loss that is incurred to you is about half of the total option premium that you have received. This is because the delta value of the out of the money call option that you have sold is about 0.4 - 0.5. The out of the money call option strike price must be the closest strike price to the entering security price.
Collar is also known as medium covered call. It is quite similar to covered call strategy. It is only added one more step in order that stop loss is unnecessary to be set in this strategy. This strategy is established by buying a security and near the money put option and following selling an out of the money option. Due to the put option that you have bought, it is unnecessary to set a stop loss because put option will protect the security if the security price goes down. However, out of the money option premium that you have collected has to be used to pay for the put option premium. If the security price goes down, you still loss about half of the total put option premium. This is because out of the money call option premium is less than the near the money put option premium. This strategy is for half or one year long term investment.
Condor strategy has four combinations. Two of them are for stationary market and the other two are for dynamic (volatile) market. Long call and put condor are for stationary market whereas short call and put condor are for dynamic market. The former strategy involves four steps that are buying and selling in the money and out of the money call option with an equivalent amount of contract. With this strategy, profit can be generated as long as the security price does not fluctuate out from the upside and downside breakeven level. Short call and put condor are for dynamic market, which also involves four steps like the long call and put condor strategy. The difference is that in short call and put condor, the strike prices of the options that have bought must be within the strike prices of the options that have sold. For short call and put condor strategy, profit can be generated as long as the security price has fluctuated out of the upside and downside breakeven level. The upside breakeven level is calculated by adding the whole position total pay out or receive to the highest strike price in the strategy. The downside breakeven level is calculated by subtracting the whole position total pay or receive to the lowest strike price in the strategy.
Combo strategy has two combinations that are bullish and bearish combo. Bullish combo strategy is for bullish market and the bearish combo strategy is for bearish market. This strategy involves two steps that are buying out of the money option and selling in the money option. If the security price goes up more than the higher strike price, profit can be generated. But if the security price goes down lower than the lower strike price, loss is incurred. If the security price fluctuates within the higher and lower strike price, you won’t loss anything. This strategy can earn an unlimited profit but also will cause an unlimited loss depending to the market direction and also which strategy you have used.
Butterfly spread strategy is quite similar to the condor strategy. It has also four combinations that are long at the money call and put butterfly spread and short at the money call and put butterfly spread. Long at the money call and put butterfly spread are for stationary market and short at the money call and put butterfly spread are for volatile market. Steps that involve in long at the money call butterfly spread are buying in the money and out of the money call option and following selling at the money call option. At the money option means the strike price of this option is quite close to the current market security price. Number of contract of the at the money call option must double the number of contract of in and out of the money option. Profit can be generated as long as the security price does not move out from the upside and downside breakeven range. The upside breakeven level is calculated by adding the total pay out of this position to the highest strike price. The downside breakeven level is calculated by subtracting the lowest strike price with the total pay out of this position. The short at the money call butterfly spread is established by selling in and out of the money call option and following by buying at the money call option. Number of contract of at the money option must be double the number of contract of in and out of the money option. As long as the security price has move out the upside and downside breakeven range, profit can be generated. This strategy generates limited profit and also cause limited loss if the security price does not go to the right direction.
Calendar spread is also known as horizontal or time spread. This strategy is solely used to earn money from the security, which price trades sideway. There are quite number of stocks have this kind of price trend. This strategy is established by selling at the money call or put option, which has a shorter time to expiry and buying at the money call and put option, which has a longer time to expiry. This strategy merely generates the money from the time value of the option. The option that has shorter time to expiry depreciates the time value faster than the option that has longer time to expiry. Usually, the option that has shorter time to expiry is left for expire worthless. The total money that you receive after closing this position will be more than the total money that you have paid out when opening this position.
With these ten strategies, you can use to earn money from upside and downside market and also the market that trades sideway.
Before learning how to trade option, terminologies that you need to know are as follow:
a) Strike price: Strike price is the price that is agreed by both buyer and seller of the option to deal with. That means if the strike price of the call option is 35, seller of this option obligates to sell security at this price to the buyer of this option even though the market price of the security is higher than 35 if the buyer exercises the option. Buyer of this option can buy a security with a price that is lower than the market price. If the current market price is $39, the buyer will earn $4. If the security price is lower than the strike price, buyer will hold the option and leave the option to expire worthless. For put option strike price, buyer of the option has the right to sell the security at the strike price to the seller of the option. That means if the put option strike price is 30, seller of this option obligates to buy the security at this price from the buyer if he or she exercises the option even though the market price is lower than this price. If the market is $25, the option buyer will earn $5. It looks like a lot of transactions have been involved; but actually, seller of the option will not buy a security and sell it to the buyer. The broker firm will do all the transaction but the extra money that has used to buy the security has to be paid by the seller. This means, if the seller loss $4, the buyer will earn $4.
b) Out of the money, in the money and near/at the money option: Option price comprises of time value and intrinsic price.
Time Value + Intrinsic Value = Option Price
Time value is the amount of money that the option worth due to the time the option has until its expiration date. Longer the time the option has until its expiration date, higher the time value of this option. Time value of an option will become zero if the option has expired. Intrinsic value for in the money call option is the difference between current market security price and option strike price. Conversely, in the money put option’s intrinsic value is the difference between option strike price and current market security price. If the current security price is lower than the call option strike price, this option is an out of the money option. It only has time value. Call option with strike price that is lower than the current market security price is an in the money option. This option has time value and also intrinsic value. Near or at the money option is the option, which strike price is close to the current market security price.
c) Delta value: Delta value shows the amount of the option price will change when the security price changes by $1.00. It is a positive value for call option and negative value for put option. It ranges from 0.1 to 1.0. Delta value for in the money option is more than 0.5 and out of the money option is less than 0.5. Delta value for deep in the money option usually is more than 0.9. If the option delta value is 0.6, meaning that when the security price goes up $1, option price will go up $0.60. If the security price goes up $0.10, the option price will goes up $0.06. Usually, $0.06 will round up to $0.10.
d) Theta value: Theta value is a negative value, which shows the decay of the option time value. Option, which has longer time to expiry, has lower absolute theta value than option, which has shorter time to expiry. High absolute theta value means the option time value decays more than the low absolute theta value option. A theta value of -0.0188 means that the option will lose $0.0188 in its premium after passage of seven days. Options with a low absolute theta value are more preferable for purchase than those with high absolute theta value.
e) Gamma value: Gamma value shows the change of the delta value of an option when the security price increases or decreases. For an example, gamma value of 0.03 indicates that the delta value of this option will increase 0.03 when the security price goes up $1. Option, which has longer time to expiry, has lower value of gamma than option, which has shorter time to expiry. The gamma value also changes significantly when the security price moves near the option strike price.
f) Vega value: Vega value shows the change of the value of option for one percent increase in implied volatility. This value is always positive. Near the money option has higher vega value compared to in the money and out of the money option. Option, which has longer time to expiry, has higher vega value than the option, which has shorter time to expiry. Since vega value measures the sensitivity of the option to the change of the security volatility, higher vega value options are more preferable for purchase than those with low vega value.
g) Implied volatility: Implied volatility is a theoretical value, which is used to represent the volatility of a security price. It is calculated by substituting actual option price, security price, option strike price and the option expiration date into the Black-Scholes equation. Options with a high volatility stocks are cost more than those with low volatility. This is because high volatility stock option has a greater chance to become in the money option before its expiration date. Most purchasers prefer high volatility stock options than the low volatility stock options.
Actually, there are twenty-one option trading strategies, which most of the option investors and traders use in their daily trading. However, I’m only introducing ten strategies as follow:
a) Naked call or put
b) Call or put spread
c) Straddle
d) Strangle
e) Covered call
f) Collar
g) Condor
h) Combo
i) Butterfly spread
j) Calender spread
Naked call and put meaning buy call and put option only at the strike price, which is close to the market security price. When the security price goes up, the profit is the subtracting of the security price to the strike price if you buy call and the reverse if you buy put.
Call and put spread is established by buying in the money or near the money option and selling out of the money option. When the security price goes up, in the money call option that you buy will generate profit and the out of the money option that you sell will loss money. However, due to the difference of the delta value, when the security price goes up, in the money call option price goes up with a higher rate compared to the out of the money call option. When you deduce the profit from the loss, you still earn money. The purpose of selling the out of the money option is to protect the depreciation of time value of in the money call option, if the security price goes down. However, if the security price continuously goes down, this will cause an unlimited loss. Therefore, stop loss has to be set at certain level. This strategy also has a maximum profit that is when security price has crossed over in the money option strike price.
Straddle can earn money no matter the security price goes up or down. This strategy is established by buying near the money call and put option at the same strike price. The disadvantage of this strategy is the high breakeven level. The sum of the call and put option ask price is the breakeven level of this strategy. You only generate profit when the security price has gone up or down more than the breakeven level. If the security price fluctuates within the upside and downside breakeven level, you still loss money. The money that you loss is due to the depreciation of the option time value. This strategy is usually applied for the security, which has high volatility or before the release of the earning report. The maximum loss of this strategy is the total amount of call and put option price. This strategy can generate unlimited profit at either side of the market direction
Strangle is quite similar to straddle. The difference is strangle is established by buying out of the money call and put option. Because both the options are out of the money option, therefore, both options have different strike. The maximum loss of this strategy is less than the straddle strategy, but difference between the upside and downside breakeven level is slightly higher than the straddle strategy. For this strategy, the upside breakeven is calculated by adding the total call and put option prices to the call option strike price. While, the downside breakeven level is calculated by subtracting the put option strike price with the total call and put option prices. The difference between the strike prices usually is about 2.50 or 5 depending to which stock that you select to buy with this strategy. If the security price fluctuates within the upside and downside breakeven level, you still loss the money due to the loss of the option time value. Application of this strategy is the same as the straddle strategy.
Covered call is established by buying a security at the current market ask price and selling out of the money call option. Selling out of the money option has limited the profit that generated from this strategy. If security price continuously goes down, it will cause an unlimited loss. Therefore, stop loss must be set. When the option has comes to its expiry, if the security price is not moving up significantly, you still earn the total option premium that you have received. If the security price goes up, sure you will earn a limited profit. If the stock price continuously goes down, it will cause an unlimited loss. Therefore, stop loss must be set. Usually, stop loss is set at the security ask price after subtracting by the option bid price. If this security price goes down and passes over the price that you set as stop loss, the loss that is incurred to you is about half of the total option premium that you have received. This is because the delta value of the out of the money call option that you have sold is about 0.4 - 0.5. The out of the money call option strike price must be the closest strike price to the entering security price.
Collar is also known as medium covered call. It is quite similar to covered call strategy. It is only added one more step in order that stop loss is unnecessary to be set in this strategy. This strategy is established by buying a security and near the money put option and following selling an out of the money option. Due to the put option that you have bought, it is unnecessary to set a stop loss because put option will protect the security if the security price goes down. However, out of the money option premium that you have collected has to be used to pay for the put option premium. If the security price goes down, you still loss about half of the total put option premium. This is because out of the money call option premium is less than the near the money put option premium. This strategy is for half or one year long term investment.
Condor strategy has four combinations. Two of them are for stationary market and the other two are for dynamic (volatile) market. Long call and put condor are for stationary market whereas short call and put condor are for dynamic market. The former strategy involves four steps that are buying and selling in the money and out of the money call option with an equivalent amount of contract. With this strategy, profit can be generated as long as the security price does not fluctuate out from the upside and downside breakeven level. Short call and put condor are for dynamic market, which also involves four steps like the long call and put condor strategy. The difference is that in short call and put condor, the strike prices of the options that have bought must be within the strike prices of the options that have sold. For short call and put condor strategy, profit can be generated as long as the security price has fluctuated out of the upside and downside breakeven level. The upside breakeven level is calculated by adding the whole position total pay out or receive to the highest strike price in the strategy. The downside breakeven level is calculated by subtracting the whole position total pay or receive to the lowest strike price in the strategy.
Combo strategy has two combinations that are bullish and bearish combo. Bullish combo strategy is for bullish market and the bearish combo strategy is for bearish market. This strategy involves two steps that are buying out of the money option and selling in the money option. If the security price goes up more than the higher strike price, profit can be generated. But if the security price goes down lower than the lower strike price, loss is incurred. If the security price fluctuates within the higher and lower strike price, you won’t loss anything. This strategy can earn an unlimited profit but also will cause an unlimited loss depending to the market direction and also which strategy you have used.
Butterfly spread strategy is quite similar to the condor strategy. It has also four combinations that are long at the money call and put butterfly spread and short at the money call and put butterfly spread. Long at the money call and put butterfly spread are for stationary market and short at the money call and put butterfly spread are for volatile market. Steps that involve in long at the money call butterfly spread are buying in the money and out of the money call option and following selling at the money call option. At the money option means the strike price of this option is quite close to the current market security price. Number of contract of the at the money call option must double the number of contract of in and out of the money option. Profit can be generated as long as the security price does not move out from the upside and downside breakeven range. The upside breakeven level is calculated by adding the total pay out of this position to the highest strike price. The downside breakeven level is calculated by subtracting the lowest strike price with the total pay out of this position. The short at the money call butterfly spread is established by selling in and out of the money call option and following by buying at the money call option. Number of contract of at the money option must be double the number of contract of in and out of the money option. As long as the security price has move out the upside and downside breakeven range, profit can be generated. This strategy generates limited profit and also cause limited loss if the security price does not go to the right direction.
Calendar spread is also known as horizontal or time spread. This strategy is solely used to earn money from the security, which price trades sideway. There are quite number of stocks have this kind of price trend. This strategy is established by selling at the money call or put option, which has a shorter time to expiry and buying at the money call and put option, which has a longer time to expiry. This strategy merely generates the money from the time value of the option. The option that has shorter time to expiry depreciates the time value faster than the option that has longer time to expiry. Usually, the option that has shorter time to expiry is left for expire worthless. The total money that you receive after closing this position will be more than the total money that you have paid out when opening this position.
With these ten strategies, you can use to earn money from upside and downside market and also the market that trades sideway.
Alexander Chong
Author of “Workable Option Trading Strategies”
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