Teach Me Options Trading
June 27th, 2008 |Options are contracts that give the holders the right to buy or sell a certain number of underlying assets for a predetermined price. With options, you can use a relatively small amount of capital to start trading in the stock market. Unlike futures which can expose you to unlimited losses, option holders can feel secured that their maximum loss is capped.
Options give you the RIGHT but NOT THE OBLIGATION to buy or sell an asset at the exercise price (strike price), if the market goes against you, you can simply choose not to exercise the options, the maximum loss to holding an option contract is the price you paid for the options itself. You don’t suffer any more losses than that. Options are very effective in terms of risk management. That’s why so many institutional investors such as hedge funds engaged in options trading.
There are two types of options: CALL and PUT. A CALL gives you the right to buy and PUT gives you the right to sell. When the stock market goes up, as a CALL option holder you may buy stocks at the strike price (lower than the market price) specified in the contract, and immediately sell the stocks in the market to lock in the profit. When the market goes down, as a PUT option holder you can sell your stocks at a fixed, predetermined price. You are therefore protected from a stock market crash.
Exchange traded options are guaranteed against default and are regulated at the federal level. Investors tend to obsess over the choice of options: “Should I buy Citigroup? Or 3M, Microsoft?” However, one’s choice of option does not matter as much one’s overall asset allocation. Almost any underlying asset can make you money, if you choose the right strike price. The better question you need to ask is how options fit into your overall portfolio. Ideally, your portfolio should include equity for growth, debt and bonds for income streams, and derivatives for hedging. If you need to use a certain amount of money soon, don’t invest it all in options. Many mediocre investors don’t fully understand the risk profiles of each of the options strategies (Long CALL, Long PUT, Short CALL, Short PUT, and different risk-managed strategies). This group of investors are most likely to expose themselves to massive losses.
Instead of playing along the crowd, successful option traders stand apart. They know how to avoid mistakes such as:
1. Buying contracts that are too closed to expiry
Options have expiration date, investors automatically relinquish the right to exercise the options after the expiration date (i.e. the contracts may expire worthless).
2. Tying up too much cash in options
Options are derivatives, meaning the value of options are dependent on the value of their underlying assets. Unforeseeable events, such as the recent subprime credit crisis or the 9/11 event a few years ago, will create significant market volatility in the options market. If you hold stocks, you can wait for the stock prices to rebound after the market turmoil. Stock options, on the other hand, can expire worthless.
3. Investing in over-the-counter options without fully understanding the risks
OTC (Over the counter) options are not regulated, therefore, there is significant default risk involved. OTC are more customized and they are mainly for big institutional investors.
Institutional investors can make $1,000,000s trading options, yet most individual investor lose in the options market. Find out why at ibankinsider.com.
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