Option trading has many advantages for the investor and would-be day trader - limited risk and limited exposure, if your options are covered; improved leverage that can give you far better returns than stock or mutual fund investments and the ability to profit in bull and bear markets alike. Here is The Investor magazine's guide to options trading.
An option is the right to sell or buy property, usually equity, at a predetermined price on or before, a predetermined date. To acquire this right, the taker (buyer) pays a premium to the writer (seller) of the contract, however while the contract gives the right to buy or sell the property, there is no obligation to buy or sell the property
There are two types of options available: call options, which give the taker the right to buy underlying shares, and put options, which give the taker the right to sell the underlying shares. In both cases, the purchase or the sale may take place before the predetermined date and there is no obligation to buy or sell the shares unless the option is exercised. The largest market for the options is the Chicago Board of Options Exchange (CBOE) where most of the trading used to be carried out via open outcry on the floor of the exchange. Today, however, most CBOE trading is now done online using computers.
The advent of the Internet has opened up the US options market and anybody can trade US options online from a computer from any location in the world. In addition to the CBOE, there are five other US Exchanges where options are bought and sold: the American Stock Exchange (AMEX); the International Securities Exchange (ISE); the Pacific Exchange (PACX) the Philadelphia Stock Exchange (PHLX) and the Boston Stock Exchange (BOSX)
There are two reasons why you may purchase a call option. The first is that you simply want to buy the right, but not the obligation to buy the shares at a fixed price (the strike price) and by a fixed time (expiration month).
For example, say this is January and you want to buy 1,000 shares of company ABC for a strike price of $10 in 12 months time, because you do not have funds now to complete the purchase but plan to have the funds available in December. You would buy 10 contracts (100 shares = 1 contract) of the December $10 call option, for say $2, which would then expire on the third Friday of December at 4pm EST (New York Time).
If the share price is trading at $20 on the third Friday of December you could exercise your right to buy the shares at $10 and either hold onto the shares or sell the shares back to the market for $20 and make an $8 per share profit. If you don't exercise your option on or before the third Friday of December then you lose the opportunity to profit and consequently lose your $2 investment.
Also, if the share price happens to be trading lower than $12 on the third Friday it may not be worth your while to exercise your option therefore you cut your losses and decide to lose the price of your option.
In the ABC example above, where the share price moves from $10 to $20 in 12 months instead of exercising your right to buy the share for $10 and selling the share for $20, you can simply sell the call option you bought for $2 for $10 and gain a profit of $8.
If the share price moves from $10 to $20 then the option price will move from $2 to $10 and can be sold for a $8 profit on or before the third Friday of December. If you forget to sell you option for $10 on or before the third Friday, you will lose your opportunity to profit from the increase of the option price. If the share price moves from $10 down to say $8 then the option you bought for $2 will be worth $0 and you will lose your $2 investment.
This is one blog in a series of blogs that I will be posting to help you learn how to pick a quality stock to invest in. If you wish to learn more about the TICN method please visit your research website www.ticn.com