Options Trading Education » T.D. Thompson

Trading Oil Options

T.D. Thompson — Sun, 14 Nov 2010 15:34:33 +0000

As hopes for a stronger world economy increase trading oil options could become increasingly profitable. In trading oil options, or trading any options, profitability is linked to price changes in the underlying equity. In this case profit in trading oil options is linked to the price of oil and to the fortunes of companies in the oil and gas industry. Recently the New York Mercantile Exchange (NYMEX) price of crude oil for December delivery rose nearly 7 percent to $87.06 a barrel. According to press reports hedge funds have been especially active in buying futures and options on oil futures. According to the Commodity Futures Trading Commission weekly report net long positions on oil reached a historic record. Succeeding in options trading in the coming months and years may well depend upon correctly reading where the price of oil is going. Specifically trading oil options will mean correctly reading oil as priced in dollars. Profitably trading oil options will also have to do with identifying the oil industry companies that are likely to capitalize of higher oil prices and those that will lose out.

Reading the dollar commonly means watching what the Federal Reserve is doing. With the USA generally dissatisfied about slow job growth (see election results) the Fed has enacted another stimulus measure destined to pump money into the economy, hopefully create jobs, and drive down the value of the US dollar. Certainly, locking in oil priced in dollars when the dollar is heading down and crude is heading up sounds like a great idea. However, the announcement that the Fed will buy $600 Billion more in treasuries is already old news and the options and futures markets have already reacted. The dollar is down 13% on the year just since its June top against a basket of major currencies. If the price of oil goes too high to fast the question will be when to buy puts on oil futures or on oil companies.

Regarding trading oil options through oil companies let’s look at a couple of examples. Exxon stock went up $4 a share to $70 (6%) as oil rose 7%. Oil exploration giant Apache Corporation saw its stock rise around 9% during the same time frame. Interestingly Australian oil exploration company, Woodside, saw its stock (denominated in AUD) drop at the same time as the dollar weakened. Successfully trading oil options will require the trader to look at a mix of oil price, dollar price in other currencies, and a company’s ability to profit from increasing energy demand. Exxon will pump more oil if demand is higher and will profit to the degree that it can pass on the higher cost of crude to the consumer as higher prices gasoline, diesel fuel, and heating oil. Companies like Apache or Woodside get paid for finding oil. Their price structures are different than Exxon’s which fact needs to be figured into expectations of higher (or lower) stock prices as energy demand increases. Obviously the Apaches and Woodsides of the world need to actually find oil to be successful. If they are successful they can outperform the big oil companies in a rising market. Even if the trader is only trading oil options in US stocks or oil on the futures exchange it will be useful to keep an eye on a company like Woodside as its denomination in AUD may give a more accurate view of how much the rise in the price of oil is because of increasing demand and how much is from the decline of the dollar. If following oil companies gets too complicated, brushing up on how to trade futures options on crude oil could be the best bet.

More Resources

When to Buy Puts

T.D. Thompson — Tue, 09 Nov 2010 01:31:53 +0000

Puts are options contracts that give the buyer the option but do not confer an obligation to sell 100 shares of an underlying stock for a price stated in the individual options contract. The same contract will confer upon the seller the obligation to buy the same 100 shares of stock at the contract price, which is called the strike price. When to buy puts is when the trader or investor expects that the stock price may go down. By purchasing a put option the person can exercise the contract in the eventuality of a fall in stock price and receive the contract price for the shares even though the spot price, the market price may have dropped substantially. When to buy puts is not when the person believes that the price of the underlying stock will stay the same or go up. In this case the trader will wish to sell puts. He will receive a premium, the price of the options contract, for bearing the risk of a possible adverse move in stock price. In general how to trade stock options is to follow the stock in question. When to buy calls is when the investor expects the stock price to go up and when to buy puts is when he expects the price to go down.

A specific example of when to buy puts is when an investor has gotten into a growth stock early and has seen a spectacular run up in stock price. He is concerned that the market has overshot on the stock price and is due for a correction. However, the stock keeps going up and he does not want to lose out on more gains. So, he does not sell the stock but he buys puts on the stock. When the stock price goes up he exits the position at the lower price by executing the opposite trade. He buys puts at that price. Then he purchases puts again at the new, higher price. This is a real example of when to buy puts and saved any number of investors during the dot com bubble a decade ago. When the market in dot coms crashed those who had covered their positions by buying puts were able to cash out of their stock positions at the high water mark and not see their gains evaporate along with their stocks. This is an example of how to trade options to protect a stock position. Another trader may simply do the same thing without owning the stock.

For the individual who does not own a stock but spots one due to fall in price this is also an example of when to buy puts. It is also a great example of how trading options can give the individual a great deal of leverage. When to buy puts is when the trader believes that a stock price is about to fall, and when the price of the option is cheap. This can take a bit of fundamental analysis as well as technical analysis but can reward the trader with a more substantial return on investment than if he were to use the same money to sell the stock short. This is because of how a well chosen option costs only pennies on the dollar compared to the price of the stock. The individual will control a larger block of stock with the option than by short selling shares. Just before their recent earnings report came out traders were buying puts on Intel with the expectation of a poor report and a drop in stock price. When to buy puts in this situation was when traders expected a drop in stock price and only wanted to establish the option to profit from a possibly poor earnings report.

More Resources

What Are Calls and Puts?

T.D. Thompson — Sat, 06 Nov 2010 01:32:17 +0000

What are calls and puts in options trading? Calls and puts are the names for the types of contracts used to buy and sell stock, commodity, and futures options. The answer to “What are calls and puts?” depends also, to a degree, upon the point of view of the trader. Calls and puts are kinds of options trading that can offer a high degree of leverage to the investor (buying) or the prospect of continuing long term profits in the hands of skilled traders (selling). The options trader looks to buy options which have a low premium (price) and for which the trader believes the underlying equity price will rise (call) or fall (put). When there is a moderate to substantial move in equity price the trader will earn a substantially larger return on his investment than if he had bought the equity or sold short.

Over the long term options writing (selling) tends to be more profitable than buying. However, because of the risk of occasional substantial loss writing options is largely the province of large institution investors with the financial reserves to absorb that occasional loss. What are calls and puts for the professional making a living trading options? They are a means of making a living by anticipating whether a stock price will rise, fall, or stay the same. The options seller looks for equities that are unlikely to go up in price (calls) or down in price (puts).

A call contract gives the buyer the option to purchase the underlying equity which he will do if the equity price moves in the direction anticipated. A call contract confers an obligation on the seller (writer) of the call option to sell the underlying equity if the buyer executes the contract. Similarly a put contract gives the buyer the option to sell the underlying equity which he will do if the equity price moves in the direction anticipated. A put contract confers an obligation on the seller (writer) of the put option to buy the underlying equity if the buyer executes the contract. Covered options trading is when the seller of a call option or buyer of a put option owns the equity in question.

What are calls and puts to buyers versus sellers of options? Buyers of both calls and puts typically engage in uncovered options trading, also known as naked options trading. Because the premium paid for the option is typically a small fraction of the price of the equity, the buyer may gain a multiple of his investment when the equity price moves. Because the options buyer will only execute the contract when doing so is profitable the maximum loss he can incur will be the premium paid for the contract. He does not need to have any collateral in case of a larger loss. On the other hand the seller of a call may well own the stock or other equity in question. Thus he will simply forego the profit if the price of the equity goes up and the buyer executes the contract but will not need to buy the stock at the higher price in order to sell it to the options buyer. What are calls and puts to the owner of an equity? In the case of selling calls it can be an extra source income when the stock price does not go up, a payment for selling a stock whose price has risen, or a means of offsetting loss if the price goes down.

More Resources

How Do Options Work?

T.D. Thompson — Sat, 30 Oct 2010 00:15:41 +0000

It is possible to buy and sell options on various underlying equities on various exchanges such as the CBOE. There are options on equity securities, index options, debt options, foreign currency options. How do options work in these different arenas? In each case the options trader will either buy or sell put options or call options. The buyer of a put option purchases the right but not the obligation to sell a defined quantity of the underlying equity at a set price, the strike price. The buyer of a call option purchases the right but not the obligation to buy a defined quantity of the underlying equity at the strike price. The seller of a put option is obligated to buy and the seller of a call option is obligated to sell if the buyer chooses to execute the options contract. Of the several kinds of options trading all can be traded profitably.

How do options work in regards to making a profit? Options traders buy or sell puts or calls on the underlying equity based upon their analysis of what the price of the underlying equity will do. Options traders will commonly exit a position when the equity and, therefore, option price changes. It is not necessary in American style options to hold the contract until expiration date. Regarding risk, how do options work? The risk of the options buyer is limited to the price of the premium paid for the option. The risk for the seller of either call or put options can be substantial if the underlying equity changes greatly in price. Learning how to trade options successfully requires knowledge of fundamentals and technical aspects of the markets in question. For the beginner in options trading it is probably best to limit options trading to buying puts or buying calls.

How do options work in the various options trading arenas? The differences between how to trade stock options and how to trade index options lies in the analysis of the underlying equity, whether it is an individual stock or an ETF based upon an index such as the S&P 500. In each case there are extensive lists of options available and minute by minute updates in the prices of the options. The trader who wants to buy options will choose an options contract on a stock or index whose price, he believes, will change (up for calls and down for puts). The trader who wants to sell options will look for stocks or indexes that will not change in price or, at least, will not change in the “wrong” direction. A put seller does not want the equity to go down in price and a call seller does not want it to go up in price. The same thinking applies to buying and selling options on Forex and debt.

In general the question of “how to do options work” is better phrased “how does Forex work” or “how do debt securities vary in price?” People ask the question “is trading currency options risky?” It is for the unpracticed and uninitiated who don’t take the time or apply the effort to learn the job of analyzing a given currency pair and how currency options vary in price in relation to the Forex market. How to options work? They can work very well for the astute trader interested in the leverage options trading offers and the risk protection that lies in buying calls and puts.

More Resources

What Are Stock Options?

T.D. Thompson — Thu, 21 Oct 2010 20:00:08 +0000

The technical answer to the question, “What are stock options?” is that stock options are derivative financial instruments that give the buyer the right but not the obligation to buy or sell 100 shares of a stock specified in the contract. Stock options are contracts that run over a specific time period. During this entire time the buyer can execute the contract if desired so long as he is trading American style options. What are stock options if they are not American style? European style options are similar to American style in all ways except that the option can only be executed at the expiration date. Traders can profit either by buying or selling calls or by selling calls or writing puts in options trading. It all depends upon the price of the option and where the trader believes that price will go next.

What are stock options worth? The value of a stock option is based upon the underlying equity, the stock. The value of the option is directly related to the stock price on call options. The value of the option is inversely related to the stock price for put options. What are stock options as relates to calls and puts? In a call option the buyer of the option purchases the right to buy the underlying stock. In a put option the buyer of the option purchases the right to sell the underlying stock. Knowing how to trade stock options profitably starts with understanding the difference between puts and calls as well as buying and selling options.

Of the kinds of options trading, selling options and buying options are really different places inhabited by different people. What are stock options to the seller? They are a way to make money on stocks that, the seller believes, will not change in price, at least in the direction the buyer believes. It turns out that over the long run it is commonly more profitable to sell options than to buy them. However, there are two types of risk in selling options. In selling a call option the seller runs the risk of missing out on a substantial rise in stock price as the buyer will exercise the option and only have to pay the contract price. In selling put options the risk is that the stock price will drop substantially. Then the buyer will sell at the contract price. The seller will pay the contract price for the stock but own an equity that is substantially less valuable. Because of this risk most of the traders selling puts are large institutional investors with the financial reserves to absorb the occasional large loss.

What are stock options to buyers? For both occasional options trading and for making a living trading options, selling options provides the buyer with a great deal of leverage. He or she can purchase the right to buy or sell for a few percent of the value of the stock in question. If the stock price moves as the buyer anticipates it is possible to earn a multiple of what is invested whereas the buyer of the same stock may only profit by a fraction of the capital invested.

More Resources

How to Buy Stock Options

T.D. Thompson — Wed, 20 Oct 2010 02:27:27 +0000

Learning how to buy stock options is a necessity for options trading. All options traders must read the document, “Characteristics and Risks of Standardized Options,” which is also known as the “Options Disclosure Document.” This publication of the Options Clearing Corporation provides detailed information as to how to trade options, types of options trading strategies, and lists of options exchanges. Reading this document and other available material is a good start on how to buy stock options. Traders will need to open an account with a stock broker. The trader will then be able to trade online or simply call in his trades. A margin account is necessary for traders interested in writing calls and writing puts in options trading. The margin account will be the limiting factor in how many options the trader sells at one time. Margin requirements vary from broker to broker but the margin must be sufficient to cover the purchase or sale of options should all buyers choose to execute their options contracts.

Although an options trader will need, at least, to say that he has read the options disclosure document before trading it is obviously better if he has. There are a number of ways in today’s world to learn about options trading. One is to read the dry facts. Another is to take an online training class and a third is to practice in simulation trading with the help of a coach. All of these approaches can be combined to give the trader a broad view of how options trading works. However, to start using strategies such as a short straddle or long straddle the trader will need more than just familiarity with the mechanics of options trading. How to buy stock options successfully always includes a substantial knowledge of the underlying stock. Traders will need to do fundamental and technical analysis of the stocks for which they wish to buy, or sell, options.

An important aspect of how to buy stock options is choosing the option or options to buy. There are easily more than 3,000 stocks on which options can be traded and over 900 indexes. No one, with any sense, is going to try to trade all of these. The most successful kinds of options trading will typically center on a few stocks which the trader studies and follows closely. He will pick stocks that his fundamental and technical analyses tell him will change dramatically in price, up for calls and down for puts. Because options contracts are for a limited period of time a trader is not looking for stocks that will gradually appreciate over time, no matter how promising their prospects. If an investor is looking for these stocks he will typically just buy them. How to buy stock options profitably is to anticipate a jump in stock price and buy call or put options accordingly. How to buy stock options profitably includes using the leverage that stock options offer. A trader can buy a stock option for a fraction of the cost of the stock. If the stock changes a few percent it is possible obtain a return on investment several times the price of buying the option by simply exiting the options position after a price jump and never owning the stock.

More Resources

Is Trading Currency Options Risky?

T.D. Thompson — Sun, 17 Oct 2010 15:18:19 +0000

Is trading currency options risky? If you assume that trading foreign exchange options is easy and approach it that way then, yes, it is risky. If you prepare yourself and learn the trade then making a living trading options on currencies is absolutely possible. The first thing to remember when posing the question “is trading currency options risky?” is that all investment carries risk and that learning risk management is a large part of successful options trading.

The basic risk of trading currency options is that of trading currency pairs in foreign exchange. The trader should know and understand the economic, political, and central bank policy factors that drive the value of a nation’s currency. The other major factor has to do with the kinds of options trading in which a trader engages. Is trading currency options risk when you are buying puts or calls? The risk is limited to the price of the premium. Is trading currency options risky when you are selling puts or calls? When selling options the risk is potentially unlimited and is typically the province of large institutional traders with very substantial financial reserves.

How is trading currency options risky as relates to a nation’s economy? An excellent example is matter of sovereign debt among the nations of the European Community. For those who correctly anticipated the fall in the value of the Euro versus other currencies the PIIGS (Portugal, Italy, Ireland, Greece, Spain) debt issue led to good times for trading options in the Dollar, the Yen, or the Swiss franc versus the Euro. For those who were caught unawares the results were often devastating. The question might be posed as follows. If you don’t pay attention to your options trades is trading currency options risky? Then the answer is a resounding yes. Like all options trading you need to stay tuned in to what is going on in the nations whose currencies you trade. To the extent that you have purchased options the risk only lies in the premium paid and the risk can be less than if you trade the currencies directly. If you have sold options you need to be able exit the options trade as soon as possible in order to limit your losses.

A currency option gives the buyer of a call option the right to buy one currency with another at a specified price no matter where the market may take the relative values of the two currencies. It gives the buyer of a put option the right to sell. In neither case does buying an option confer an obligation. The risk is in losing the premium paid. When is trading currency options risky? In selling puts or calls the trader takes on the obligation to buy in the case of a put or sell in the case of a call if the buyer so chooses. The buyer will choose to execute the contract if it is profitable to do so. That means that the seller will incur a loss which can be substantial in the case of a large shift in relative values of the currencies involved. The best risk management in option trading for beginners is probably to avoid selling puts and calls altogether, even though in the long run selling options tends to be more profitable than buying them.

More Resources

How to Trade Options

T.D. Thompson — Sat, 09 Oct 2010 13:22:20 +0000

To learn how to trade options successfully the beginning trader will want to start with the basics. There several kinds of options trading, broken down into buying or selling put options or call options. When a stock options trader buys a put option or call option he or she pays what is called a premium for the right to buy (call) or sell (put) 100 shares of the underlying stock at an agreed upon price no matter if the stock price goes up or down. The buyer is under no obligation to buy or sell and will only execute the options contract when the stock price moves favorably. The seller of puts or calls receives the premium from the buyer and is obligated to sell or buy if the buyer executes the contract. Over the long term large institutional traders find that selling options is often more profitable than buying them. However, there can be substantial risk in learning how to trade options, especially with selling puts, which is why selling options is largely the province of large institutional traders.

When a trader buys a call option he pays for the right to execute the contract and buy 100 shares of stock at any time during the term of the contract. This is an American style options contract. Many traders will not, in fact, execute the contract but will simply exit the trade for a profit if the stock price goes up. This is because when the stock price goes up on a call option so does the value of the contract. It becomes “in the money.” Many traders making a living trading options use options trading because of the leverage it offers the trader. A trader can buy an options contract for a few percent of the cost of buying the stock. If, for example, the cost of the option is 3% of the stock price and the stock goes up three percent the price of the option can roughly double. If the trader then exits the contract by simply selling the same option for the same expiration date he will roughly double his money (adjusting for fees and commissions). The person who buys the stock will make three percent on his investment minus fees and commissions. How to trade options is to take advantage of the inherent leverage in options trading.

For the person engaged in occasional options trading it is often best to engage in buying puts or calls in that the trader pays for the opportunity to profit if the stock price goes up on a call or down on a put option. The only risk the trader will have is the cost of the premium. How to trade options for the long term stock investor is, occasionally, to sell calls on stocks they own. An investor who owns cyclical stock will have a fairly clear sense of the range in which the stock trades. The investor may sell calls on the stock near the top of the range with the expectation of the stock not going any higher. Thus the option will not be executed. In this case the investor retains the stock and profits by the price of the premium. His risk is if the stock breaks out of its trading range and he misses out on a jump in the stock price. How to trade options, for the beginner, is to avoid selling puts. This is the one situation in which the seller can sustain substantial losses if the stock price moves unexpectedly.

More Resources

How do Stock Options Work?

T.D. Thompson — Fri, 01 Oct 2010 02:04:53 +0000

For the investor interested in protecting recent stock gains a pertinent question is how do stock options work? For the trader interested in applying more leverage to his trades a useful question is how do stock options work? For the long term investor interested in increasing his current returns on his portfolio a good question is how do stock options work? Stock option trading can be fairly simple. The trader will buy or sells calls or puts on a stock. It can also be a little more complex such as when a trader uses a long straddle or a short straddle. There are as many answers to the question how do stock options work as there are kinds of options trading.

There are two basic types of options. These are calls and puts. Buying a call on a stock gives the buyer the right but not the obligation to buy the underlying stock, 100 shares per contract, up until the contract expiration date. The price to be paid is specified in the options contract and is called the strike price. Selling a call on a stock confers the obligation to sell 100 shares of stock per contract at the strike price if the buyer chooses to execute the contract. It can be more profitable making a living trading options by selling calls (or puts) but there is the risk of an occasional substantial loss if the underlying stock price changes substantially and in the wrong direction.

Puts are the opposite of calls. Buying a put confers the right to sell 100 shares of stock per contract and selling a put confers the obligation to buy the same 100 shares at the agreed upon contract, or strike, price. As with calls, put contracts have a finite duration during which the buyer can choose to execute the contract. With both puts and calls the buyer pays a premium to obtain the right to buy or sell. The seller gains the premium. The buyer of an options contract buys because he expects the price of the underlying stock to move sufficiently to obtain a profit. With buying calls the buyer expects a rise in price and with buying puts the buyer expects a fall in price. In each case the seller does not expect there to be a price change (up for calls and down for puts) that would cause the buyer to execute the contract. Risk management in option trading requires that sellers of options have sufficient assets to cover the occasional loss. This is partly why selling puts is largely the province of large institutional traders. Losing on a call option just means that the trader will forego the profit of a rise in stock price. Losing on a put option can result in very substantial losses as the seller of the put needs to buy the stock at a now higher price and sell at the new, lower price.

A question related to how do stock options work is what is an option worth? The value of an option varies with the price of the stock. The trader can exit his trade by executing the reverse trade. Thus the trader can profit from the stock price change with just the investment of the premium without buying or selling the stock. For the serious trader willing to put in the time and effort stock options trading can be a profitable endeavor.

More Resources

How to Trade Stock Options

T.D. Thompson — Sat, 11 Sep 2010 15:25:22 +0000

How to trade stock options successfully encompasses a range of issues. The first thing that many prospective options traders think of is that one can trade options with a high degree of leverage and, thus, invest less money in the process. Many simply see options trading as a cheaper substitute for stock trading. There is more to how to trade stock options than these first impressions. There are two basic kinds of options trading, buying and selling. Buying puts or calls on stock costs money, but the risk is limited to the cost of the premium paid to buy the option. Selling puts and calls is often more profitable in the long run but entails a risk if the stock price moves unexpectedly and substantially.

Someone engaging in occasional options trading will commonly sells calls in order to lock in the opportunity to buy a stock if it goes up. Likewise the occasional trader may be someone who buys puts in order to protect gains on a somewhat volatile stock. The investor will have gained substantially on a hot stock. He or she will want to hold on to the stock in the belief that it will rise even higher. However, the investor buys puts on the stock as an insurance policy. If the stock suffers a correction the investor will still be able to sell the stock at the strike price, the contract price even thought the spot price or market price will have dropped. In fact, the investor may well use the money earned from selling the stock to repurchase at the new, lower price.

How to trade stock options successfully includes understanding the basics of the underlying stock. This is the stock which an options contract confers the right to purchase or sell. Just as in buying and selling stock the investor or trader will do both fundamental and technical analysis of the stock in order to anticipate price movement. If the trader or investor anticipates either large price trends or just daily fluctuation sufficiently well he or she will be able to trade profitably. Profit in options trading comes from understanding how strike prices and spot prices in options trading come to diverge. Unlike the long term investor who looks for a margin of safety in a stock an options trader may look for stocks without a safety margin. These stocks may well be ready for a price correction and can be profitably traded by buying puts. Like a long term investor a trader in options may look for a stock with the promise of strong growth. In that case the trader will buy calls on the stock with the expectation that the stock will rise in price leading to profits.

There is really nothing magic in how to trade stock options. Success comes from learning the basics of how options trading works, developing a stock options trading strategy, and trading with discipline while auditing trading results. A strategy can be a long options strategy or a short options trading strategy. The important part is that the trader does both the necessary fundamental and technical analysis and avoids the twin demons of fear and greed that can derail an otherwise effective trading strategy. In the end, trading with discipline is how to trade stock options successfully.