How to Trade Stocks and Options

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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If you are an aspiring trader who want to know how to trade stocks, be warned, there is a lot to learn and the real world of stock trading is not kind to those who lack knowledge or make mistakes, in fact it can be very costly. So be prepared for a lot of reading, studying, and practicing, and even when you believe you are ready to join the throng and make your first trades, do so with caution, make sure you have a plan to follow and know how to manage risk.

The key part of managing risk is to limit the losses that you are inevitable going to have. All traders experience losing times, even the great Warren Buffet does, and his first rule of trading is “Don’t lose money.” And in case you haven’t heard it, his second rule is “Don’t forget the first rule.”

The would-be stock trader needs to open an account with a stockbroker. A stockbroker is the essential link between the trader and the stock exchanges where the buying and selling of stocks, bonds, ETF’s, options, futures, mutual funds, and other financial securities occurs.

In today’s online world, most trading activity takes place with online stockbrokers. It is not difficult to open an account with an online stockbroker but it will take a little time to become familiar with how to get around the trading platform interface, to learn how to place trades, get stock quotes, access stock charts and modify them to suit personal preferences. And there are other such things, including knowing what learning resources are available. To become proficient in getting around and accessing what you need to find will probably require the aid of a help desk or technical advisor from within the brokerage, but that in itself is an essential learning experience much like any computer involvement and it is relatively easy.

The basics of the basics in how to trade stocks
But adequate market knowledge in learning how to trade stocks is not something that can be accomplished by a few visits to the internet. It will take diligent study. There are books to read, and financial newspapers such as the Wall Street Journal or the Investor’s Business daily to read or at to least become familiar with in order to know what they have to offer, those and financial magazines should become reading material of habit over time especially when actually trading and gaining some success – which you will if you learn properly.

Internet resources
There are many informative videos and seminars available to watch and listen to, they are free and cover a wide range of stock market topics that can be absorbed gradually. In addition to instruction and training in specific stock trading topics, it is worthwhile to read more general material if sufficient time is available, to become familiar with the jargon and the lore of the stock market and trading of today and of the past, that can be a fascinating and diverting source of information. A good local public library should have many stock market related materials, books or videos, available.

While learning, check daily or every few days into Finance.yahoo.com or Marketwatch.com, those sites will bring you up to date with news of what is currently happening in the market plus there is plenty of other information of value to be found on them.

Stock charts, an important area of study
It is important to learn about stock charts and how to interpret patterns of stock movement that can readily be seen on a chart. Many recognizable stock patterns can provide fairly reliable signals upon which trading action can be based. Charts can depict clearly the underlying trends of the market and where areas of resistance or support are likely to occur. The trader frequently awaits those times to see when it can be confirmed that one of those confining levels is broken through, with the expectation of continued movement in the direction of the break out.

Virtual or Paper Trading
There are also resources for those learning how to trade stocks in which a form of virtual trading can be carried out, where real day-to-day trading actions to buy or sell can take place but without using real money. Using this method enables practice trading and implementation of much newly learned trading information such as trading strategies that identify what to trade and when to trade. From the results obtained, it may help determine whether the participant is ready for action in the market with real money. Many stockbrokers provide such facilities to their clients and there are many other sources on the internet, usually without charge. For more on this topic check out: Paper Trading.

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