How to Trade Stocks and Options

For the person who is already familiar with trading in the stock market, and who has been able to make money by trading common stocks, attention may turn to the possibility of trading options where the lure of much bigger gains can be enticing.

The bigger potential gains are accompanied by much greater financial risks. It is accepted in the profession that most non-professional traders lose money in options trading, and a lot of professionals do too. It is best to start with the simpler option strategies of buying calls and puts while the many other more complex strategies can be considered later.

The most important factor is to be able to identify stocks that have a high likelihood of moving up or down in price from their current level, coupled with the ability to forecast within what timespan the move should occur. With options, timing is very important, options gradually lose their value every day until they can expire worthless, as most options do. That is why they are called a wasting asset.

The main advantage of trading options is the substantial leverage they provide and the smaller amount of working capital needed to purchase them compared with the amount of capital to purchase stocks. Both those factors are important to the small trader, the non professional who wishes to participate in a speculative way where the risks are higher but the rewards can be greater.

This article is addressed to the speculator who has already made money in the market, is familiar with how it works and has at least a basic understanding of options – as many do but are hesitant to enter the field. The following paragraphs explain a real life option play that will show what can happen when trading options. This example should encourage further study and investigation into the subject by stock traders.

Following the above comments about trading options, I would like to describe an options play reported in a Forbes online stock market news column that appears to actually have taken place. That may make it more realistic for the beginning trader instead of just inventing a hypothetical trade, although there is nothing wrong with using a hypothetical trade, the results would still be perfectly valid but I hope the added reality aspects would be even more convincing when discussing the benefits from trading options successfully. So here goes, and this is a current play right up to date as I write this.

Today is July 14, 2010 and the following report refers to a purchase last week of options for the stock of CSX Corp, stock ticker symbol CSX. We don’t need to know about CSX Corp, just the options play is what we are interested in and how it will turn out.

Last week, on Tuesday afternoon July 06, 2010, the Forbes news service article commented that at least one investor is ready to profit if the stock price of CSX moved above $51.15 by expiration date on Friday 16, 2010. The investor had purchased approximately 7,500 CSX options. If you wish to verify this report you can find it on the internet at Forbes Markets Channel News on the page for 2010/07/06.

The details are:
July 06, 2010, with the CSX stock trading at $48.01 per share, approximately 7,500 call options for CSX were bought at $1.15 per contract with a strike price of $50 and for July expiration, Friday July 16, 2010.

So let us look at this transaction. We can see it is “Out of the Money” meaning that the $50 strike price is higher than the stock price when the options were purchased. And the options are of short term duration with the expiry just 10 days away. Ignoring the commissions involved, the break-even figure that the stock has to reach is the strike price of $50 plus the $1.15 for the option, that makes it $51.15

What happened after the option purchase
The CSX stock did go up in price after the purchase until yesterday when it reached a high of $53.90 and closed at $51.72.

There is no urgency to sell the option while the price is still rising, but let us use today’s stock and options pricing as if it was actually sold with the transaction being made at 1:47 pm, July 14, 2010 at the exact price quoted by my broker, OptionsXpress.

The CSX stock is trading at this time at $52.51 per share and the $50 strike options are quoted as bid 2.61 asked 2.68. So for the purpose of this trade example let us say the options are now sold at 2.60 just below the bid price at the time. Now we can calculate the results.

Cost of option @ 1.15 Sold at 2.60 = + 1.45 = + 226 % A great trade and a great gain in 10 days.

Compare with the gain in sale of the stock only: Cost per share $48.01 Sold at 52.51 = + 4.50 = + 09 %.

In conclusion
The type of option trade described above is not recommended for the beginner, the purchase date is too near to the expiry date and the beginner should buy options that have several months to go until expiry. With a successful longer-term options trade, the same type of percentage gain can be achieved and often many times as much.

Not all option trades turn out successfully and the above transaction carries a high level of risk but it does indicate the power of leverage where a $1.15 option can provide a 226 percent gain compared with the 9 percent gain from buying a share of stock at $48.01. However, in the case of a purchase of the stock instead of the options, it would not be likely that a sale of the shares would have been made at this time. The share buyer would normally have a long-term outlook and objective, looking for the company to do well and prosper over time and appreciate in significantly in value while providing a less risky investment. But requiring a much greater capital investment of course.

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A basic profitable strategy

There are dozens, of ways for trading options, some of them very complex, but we want to start with an effective basic strategy that can be shown to be profitable, easy to follow, and easy to implement.

There are just four “rules”, listed at the end of this piece that provide a simple way to trade options, a field where strategies of varying complexity and risk for trading are numerous.

If you can pick winning stocks, those that go up in price, you can do very well trading the options for such stocks.

The key is whether a chosen stock performs up to expectations by rising in price in the case of a call option, or falling in price in the case of a put option, and doing so within the span of time before the option expires.

Time is the important factor
If the underlying stock does not perform as expected, the option should to be sold on or before a specific pre-set target date. That would mean a loss if there has been no gain at all in the price of the stock and maybe a loss even if it has gained, those possibilities should become clearer as we identify the guidelines later. Reference will be made below to a pre-set “sell by” date.

Loss and gain
With most options, the maximum dollar loss that can occur is the fixed amount of the purchase price paid, whether the option position cost $500 or $5000, that is the most that can be lost if the option is held until the expiration date when it automatically becomes worthless. But the guidelines below establish a fixed date prior to the expiration date of the option, which may allow a smaller loss.

It should be understood, that in this type of speculation, with a series of sensible trades there will probably be some losses, what is important is that a risk management plan is followed that can minimize those losses as much as possible and preserve working capital. Obviously there must be more winners than losers to stay in the game and provide sufficient reward to compensate for the risks involved. There should also be a strategy to maximize gains when they occur, in other words, to not exit a position too soon.

The right stock for the right time
In the same way that any other stock purchase is made, the choice of stock to trade should be made after what is usually termed as “due diligence”, appropriate research in checking out the attributes and prospects of any selected list of stocks. Whether after a short or long appraisal, or for whatever reason, we must assume that a promising candidate has been chosen to make a trade in options using the simple strategy outlined here.

For stocks, or indexes, or for other optionable financial vehicles, there are normally many different options available, offered at different strike prices and for different terms (lengths of time in which the option can be exercised).

As an example, let us assume a decision is made to buy calls. To make the option trade we need to specify the following, the first requirement is fixed, based on the stock chosen after suitable research.

1. name and symbol of the underlying stock (or index)

2. strike price

3. expiration date of the option

Those last two requirements provide a myriad of alternatives. There are many strategies followed in option trading that determine the specifics of the above and the risks attached to those strategies differ. Option trading promises bigger gains but the risks are higher.

Buying a Call, guidelines for a simple option trade:
Avoiding the option strategies of highest risk, the suggested guidelines for a basic call option trade establishes specifics for the strike price and term as follows:

1. The strike price will be “in the money”, at a price below the current price at which the stock is trading. How far below? The delta value noted below can help to determine that. The deeper into the money, the higher will be the option price.

2. The expiration date will be approximately 4 to 6 months after date of purchase

An explanation of why it is “approximately”:

Option contracts expire during different months according to a pre-determined calendar and vary for different companies. The day of expiry is always effectively the third Friday of the month (although it is actually the third Saturday of the month, but there is no trading on Saturdays.) The farther away the expiration date for a given strike price, the higher the option price will be, that’s because more time is being bought. But usually when an option is sold with a month to go before expiration, it should have some dollar value left in it because of the one month of remaining time whereas it will be worth much less the nearer it gets to the expiry date.

3. Important Note: the position will be sold no later than one month before the expiration date. Always. Depending on performance (we) may just exit or we may “roll up” to a later expiration date.

4. Delta, An additional guideline
Explained elsewhere on this site, the delta is a numerical value that varies dependent on the changing price of the underlying stock. It is a useful guide in tracking the stock’s progress and to assess the potential for gain as a stock moves in price.

Choose an option with delta of about 60 to 65

In our next post, to better explain the foregoing, we will provide more details and specific examples to show how the leverage provided by a successful option trade gives a bigger bang for a buck.

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The trading of options hold a special attraction for many traders due to the leverage they provide because they usually trade at only a fraction of the price of the underlying stock. And options can significantly boost profits on winning stocks.

Perhaps you have been thinking about trading options so that you will be able to produce a little extra income, or to improve gains for a retirement portfolio, or for some other reason.

If so, before you start, some words of caution:
Trading Options are considered by many to be a high-risk market activity so for that reason alone, unless you are already well informed, it will pay to learn a little more about how to actually trade them. The general belief held by most professional traders is that the vast number of retail traders, people like you and me, the non-professionals, lose money when they trade options.
But that should not necessarily deter you, what it should emphasize is the need to learn effective strategies, to apply them properly and be careful.

In reality, options originally were created to reduce risk by providing a method to acquire an asset of greater value at a fixed price within some specified time in the future without a commitment being made to actually complete the acquisition by the specified time. In which case, the fee paid for the option is the only real cost involved in the transaction.

In the above explanation, the option is a derivative, meaning its existence is derived as a byproduct of the original asset, whether that is a stock or other type of asset.

All forms of trading and speculating are accompanied by risk but in the case of trading options it is perhaps somewhat of an advantage for the option buyer to be able to set the maximum dollar amount that can be lost when a trade is made. That maximum amount at stake being the cost of the option, and that would only become a reality when the option expires. Although I believe that most options traded do expire worthless.

When an option trade occurs, the transaction identifies:

• the name of the stock, usually called the underlying stock.
• the price at which the underlying stock will be bought or sold if the option holder chooses to exercise the option, this is called the “strike price”.
• the expiration date, the latest date that the option can be exercised. The option  can be exercised at any time up to and including that date but after that date it no longer exists.  As mentioned above most options expire in this way. The unexpired time span is referred to as the term of the option.

The standard definition of an option
A stock option is a contract related to a particular stock, between a buyer and a seller that gives the buyer of the option the right, but not the obligation, to buy or sell (depending on the type of option) 100 shares of that stock at a specified price on or before a given date.

An owner of an option, the option holder, can re-sell that option during its term before expiration or can keep the option until it expires. The option could also be exercised in accordance with the terms of the options, although that does not happen in most cases.

Just for the record, there are several other styles of options we need make only a brief reference to here, the most common alternative being called the European-style option to differentiate it from the above description known as the American-style option. The only difference is that European-style options cannot be exercised before the expiration date. The names of the option styles do not limit them to any geographical location. In this article, all other references are to the regular options, the American-style options.

Options can be bought and sold
The seller of an option is called the “writer” of an option. To sell an option is to “write” an option. If an option is written, (sold) by a trader who does not own the underlying stock it is a short trade, a common occurrence. That type of trade comes with an obligation that is evoked if the option holder wishes to exercise the option in which case the writer of the option must deliver the stock, in other words must buy the specified stock. Not all sellers of options are short sellers, in many cases the underlying stocks is owned by the seller when selling an option to a buyer and this transaction is referred to as selling a covered call.

Terminology for stocks: Long, short, and covering transactions
A stock transaction can be referred to as either “long” or a “short”
long means to actually buy the stock and
short means to sell a  stock before owning that stock and in doing so it then creates the obligation to buy the stock at some later date, called a “covering” transaction.

Selling short is a technique used to profit from a fall in a stock’s price and where the expectation of the seller is to be then able to buy it at a lower price, an expectation not always realized. A situation much the same as a long purchase being made with the expectation of the stock rising in price and that does not always happen either.

When a stock is sold short, in theory, the stock is loaned to the seller by the seller’s stockbroker, who may have to borrow it from yet another stockbroker. Eventually the seller must buy back the stock sold short and return it to the broker, called covering the short position.

Terminology for Options: Calls and Puts
An option to buy a stock at a later date is termed a call option, buying a call option is termed buying a long call
An option to sell a stock at a later date is called a put option, buying a put option is termed buying a long put

A long call option is a simple  way to profit if you are correct in forecasting that the stock will gain in price, buying  a call is the most common choice made by beginning investors.

A long put option is a simple  way to profit if you are correct in forecasting that the stock will go down in price.

Educational resources
Stock options are securities that are listed and traded on special exchanges, the world’s largest such exchange is the Chicago Board Options Exchange (CBOE). There are many sources for education and training in trading options, but the CBOE’s Learning Center might be a good place to start. CBOE tutorials can be found on the internet at http://www.cboe.com/LearnCenter/Tutorials.aspx

In Summary
There are many special terms used in trading options that we will cover in Part 2 of Trading Options, now in preparation, and we must also define some specific option trading strategies

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