Wednesday, October 22nd, 2014

Options Trading Strategy

 

Profits from trading options are directly related to a well thought out and executed options trading strategy. Whether this is a short options trading strategy when selling options or the use of long options trading to enhance profits on a stock that you own, sound analysis and careful attention to market sentiment are critical. Here are a few thoughts about which options trading strategy to use and when.

Short Options Trading Strategy

Selling Options

A short options trading strategy is required when you execute sell a call option. You are contracting to sell a stock at a set price, the strike price of the contract, if the buyer so chooses. You do not own the stock and your analysis tells you that the stock is not likely to go up in value. If the stock does not go up and the buyer does not exercise the option then you gain the value of the premium on the option. If the stock does go up in price you will lose the difference between the strike price when the option contract was made and the spot price when the option is exercised. The appropriate options trading strategy for short option selling is to be very conservative and only enter into trades in which you are very certain to make a profit. This is the world of the famous baseball pitcher, Satchel Paige, who was criticized for holding the baseball for a long time before throwing it. The hitter cannot hit the ball if it is in my hand, he is said to have commented. Likewise, you will not lose money selling options if you avoid any and all situations in which your analysis does clearly predict a profit.

Buying Options

There is no risk of buying short with options. In fact, buying options on a stock instead of buying the stock can help you limit your risk and provide a nice degree of investment leverage. If, for example, you purchase 100 shares of XYZ Corp at $100 a share you pay $10,000 plus fees and commissions. The stock goes up to $110 a share and you sell for $11,000 earning $1,000 minus fees and commissions. Without the overhead of investing this is a 10% return on invested capital. If, however, you purchase a $103 call option on 100 shares of XYZ Corp for $3 a share this costs you $300. This contract allows you to buy the stock at $103 at any time during the term of the options contract. Let us say that the stock goes up to $110 just like in our other example. In this case you can exercise the contract and have 100 shares for $10,300. You turn around and sell the stock for the market price and earn $700 minus fees and commissions. You invested $300 and earned $700 not counting the other overhead of trading. You return on invested capital is $400 which is 400/300 = 133% which is substantially better than a 10% return. And, if the stock falls in price to $90 a share the person who purchased the stock loses $1,000. The most that the option buyer loses is $300 in this hypothetical example. Buying, as an options trading strategy offers the trader investment leverage and limited risk.

Long Options Trading Strategy

Writing stock options for income is a common practice of many with very stable stock portfolios. Selling calls or puts on stocks that you own is called covered options trading. The way writing stock options for income works is that you own a few hundred shares of a very stable stock. You know that it very unlikely that the price of the stock will change very much. So, you sell call options on the stock. Because you will probably not have to sell the stock in question you will simply gain a little income from writing stock options for income. As with a short options trading strategy, the point is to be very conservative and only sell options when your analysis tells you that that likelihood of having the option executed is very remote.

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