you bought through the option is fixed while the stock itself is increasing in value.
Conversely, a put option gains value when its underlying stock moves down in price, while the timing issue is the same. The move in price still has to occur before the option contract expires or your option will expire worthless. Your put contract rights include selling a specific quantity of stock by a certain date at a specified price. If you own the rights to sell a stock at $60, but events such as bad news about the company pushes the stock price below $60, those rights become more valuable.
A significant part of your skill as an options trader is your ability to select options with expiration dates that allow time for the anticipated moves to occur. This may sound too challenging at the moment, but as you learn more, it will make perfect sense because it’s all about giving yourself time and giving the option time to deliver on your expectations. Of course, there are some basic trading rules of thumb that help, including the development of proper trade-management techniques, such as planning your exit from a position before you trade. Planning your exit is a simple but required part of any trade, and it is one good habit that will save you money and heartache if a position moves against you.
All stocks with derived options available for trading have multiple expiration dates and strike prices. There are two important pricing factors to keep in mind:
✔ Options with more time until the expiration date are more expensive.
✔ Options with more attractive strike prices are more expensive.
Information about options and your available choices are widely available on the Internet, especially from your broker. It takes time and practice to get to a point where you can pick the best options based on current market conditions and your outlook for the underlying asset. But as you read the different sections in this book, you will start to get a good feeling for how to go about this. Even more important is how you manage your emotions and how you gain trading discipline. This is best achieved by developing a maximally effective trading plan with easy-to-follow rules that includes planning for different scenarios. For more on this, see Chapter 8.
Trying different strategies before deploying them in real time
Options are different from stocks both in terms of what they represent – leverage, rights, and obligations instead of partial ownership of a company – and how they’re created, by demand. These important distinctions result in the need for additional trading and decision-making beyond the basic buy or sell considerations. Part of the learning process, as you transition from direct stock trading to options trading, is developing a new and complementary way of thinking. That includes not just evaluating the price of a stock or an index, but also how the price of the underlying asset along with other factors, such as supply and demand for the option and overall market conditions involved in options prices all come together. Your final decision, as the trade develops, may be to exercise your rights under the contract or simply exit the position in the market. Fortunately, market prices will help you with those decisions, and so will some thoughts from Chapters 9 and 18.
If you haven’t traded options in the past, your best approach (as we already mentioned) is to try out some trading strategies on paper and see how things work out. Your goal here is simple: You want to get to the point where you think of your option trades based not just on the option but on the underlying security.
Before you invest real money, you should be able to do the following:
✔ Gain a comfortable feel for the activity and characteristics of underlying stocks or indexes on which you are looking to trade options and understand their relationship both to the market and to the options related to them.
✔ To be able to mix and match sound strategies to particular market situations while keeping the preceding principles in mind.
Are these extra complications worth it? For many people, the answer is yes – especially when you consider the combined risk reduction and profit potential those options trading offers. And even though making the transition may sound difficult, the actual differences in stock and option mechanics are pretty straightforward and manageable. At the end of the day, the big advantage to options is the way they provide you with leverage while giving you a mechanism to control the rights to the stock rather than the stock itself.
An important aspect of this mental reshaping exercise involves paying special attention to how the real market action affects the value of options over time. Once you get this part of the puzzle locked in, the rest will fall into place more easily, and your paper trading will be more satisfying. Along with paper trading, you can also backtest options trading. And don’t worry about how long this learning process may take. Any time spent on decreasing your risk of big losses in the future is well spent.
Noodling out where options will work for your trading
There is a time and a place for everything. And options are used best when deployed optimally – meaning when the risk reward ratio offers you the best mix of both profit potential as well as risk reduction.
When you buy an option contract, you have two choices: You can exercise your rights, or you can trade your rights away based on current market conditions and your trading objectives. You can do either one based on what is happening in the markets or to any individual position at the particular time and by executing the best strategy for what the situation calls for. The most important thing is that you know what your choices are before making the trade because you have planned for either situation.
You can use options to reduce your risk by hedging a particular position or by hedging your whole portfolio. If your analysis of the situation makes you so bearish that you are looking to capitalize from a falling market, options are a much less expensive and uncomplicated way of selling individual stocks short. Chapter 10 is all about portfolio protection.
Options also let you leverage your positions. Because options cost less than stocks, you can participate in a market for less than if you owned the actual shares. This is an excellent way to reduce risk, as you are spending less capital but potentially getting a similar rate of return to what you might receive if you owned the actual underlying stock, depending on your position size. You can apply this leverage even more astutely if you are speculating and are willing to cap your profits.
This book is mostly about options on individual stocks. But index options are also an important part of the market, which may be of interest and use to you at some point in your trading life. The most important fact at this point is to understand the major differences between options on indexes and individual stocks. Here are some important general facts:
✔ You can
