Why You Should Choose Options Trading
In the last several years, more people are starting to figure out what we at Netpicks have known for a long time now; that Options Trading may be one of the best vehicles to make money with in the markets.
As a matter of fact, we generally limit our involvement to 10 names that have historically performed very well for us and others who we’ve introduced to options.
Before we get too far ahead, let’s talk about what an “option” is.
Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.
They are a derivative, which means its value is derived from the value of the stock or other instrument.
There are 2 categories of options that you must be familiar with:
- A Call option gives the trader the right but not the obligation to buy shares (100 per options contract) of a stock at a predetermined price before the future expiration date
- A Put option gives the trader the right to sell shares (100 per options contract) at a predetermined price before the future expiration date
Quick Benefits Tutorial Of Trading Options
There are a handful of reasons that may prompt you to explore options further and these are the ones that interested us:
Flexibility – Options can be used for hedging purposes, simple directional plays or even finding profits in markets that are oscillating between two price extremes. You will learn about terms such as Iron Condors, straddles and butterflies but in this introduction, simply consider those part of an overall options trading playbook. You may find yourself having great success with keeping things simple with basic calls and puts.
For now just understand that you don’t have to be right on the direction of the market in order to make money trading options.
Leverage – You are able to purchase or sell 100 shares (minimum for an options contract) of an equity such as a stock for only a percentage of what you would pay to own the stock outright. Let’s take a simple example of stock ABC where each share is $50. If you were interested in making a bullish play with this stock, you would need to front $5000 for 100 shares ($50/share X 100). You can control or take advantage of a move in that stock through a simple options play for $500.
Risk Control – Success in trading hinges on your ability to control your risk in any instrument you are trading. If you are trading futures or stocks you can actually lose more through slippage and gaps then you originally planned. Your risk with option is the premium you paid for the options contract. Be able to control with accuracy the financial risk you are taking is one of the huge benefits of getting involved with options trading.
What Makes Up An Options Contract
Earlier we touched on two elements of an options contract, calls and puts. Those are not the only aspects of the contract and you should be familiar with the following:
- What security the option contract covers – This is called the underlying asset and it simply is the stock such as Google that you will be trading the option with.
- Number of shares – One options contract covers 100 shares of the stock (at a much better price). You are able to trade more than one contract.
- Strike price – Quite simply, this is the price that has been agreed upon to buy/sell the underlying instrument (such as Google) before the expiration date.
- Expiration date – This is the day that the contract expires and it is usually on the third Friday of the expiration months.
What Makes Up The Price Of The Option
Several variables are taken into account when the price of the option is calculated. Keep in mind that there is a “wildcard” when it comes to the pricing of options: Volatility.
Volatility constantly changes throughout each trading session. So the pricing model actually works backwards to determine which level of volatility is being used to generate the current price of an option. It takes the 5 known inputs and backs them out of the current option price being quoted to get the volatility.
Your Options Strike Price
Remember that the strike price is the agreed upon amount that the underlying asset, if exercised, will be bought or sold at. We can compare the strike price with the actual price of the asset we are trading through the options contract. We call this relationship intrinsic value and will be a determining fa
- At the money: This is where the strike price and the stock price is the same and applies to both calls and puts
- In the money: With a call option, the strike price is below the price of the actual stock. An in the money put option has the strike price above the stock price
- Out of the money: Where a call option strike price is above the stock price. An out of the money put option has the strike price below the stock price
As you progress and gain experience, these terms will become second nature to you. The relationship between the stock price and the strike price will determine if there is intrinsic value and only “in the money” options will have intrinsic value.
What Is a Premium
This is the money you will pay to the seller of the option. It is stated as a per share amount and since each contract contains 100 shares of a stock, make the x100 calculation. If you are trading an in the money contract, expect to pay a higher premium for the contract.
Call Option Trade Example
You’ve decided to take your first options trade and have chosen a call option on stock ABC. Now what? There are so many strategies to trade options and for this example, let’s keep it basic with a bullish directional play and we will use a strike price of $50.
Before expiration, you can trade the contract
Imagine that after purchasing the contract, the value of ABC has risen to $60/share on good company earnings. Remember that you have the right, not the obligation, to buy the stock and in this instance, you choose not to. You exercise your option and pocket, before any fees and commissions, $10/share or $1000 ($10/share x 100 shares).
Hold to expiration
Perhaps you decided you wanted to actually own the ABC stock because you believe that the stock had great earnings and will continue to be a sought after stock. Given the same scenario as above, you exercise your right to buy at $50/share even though the stock is sitting at $60/share. The seller of the option has the obligation to sell me the asset at the agreed upon strike price.
Let it expire
It turns out that the good earnings from ABC was simply a calculation error and the stock price has tumbled to $35. It is worthless to you at this point and you simply let it expire. Here is why we love options: The stock can fall to $0 and since my risk was limited to the price of the option, I don’t hold worthless stock like I would if I exercised my right to buy.
Real Options Trading – AAPL (Apple) – 133% Return
Apple is still one of the most popular stocks to trade for day traders and swing traders alike in options investing. It is a very liquid product, with both the shares of stock and the options very active on a daily basis. We like trading it because it doesn’t like to stay quiet for long. It is also an easy name to see defined ranges in.
If market volatility picks up, there are endless ways of trading AAPL with the use of many different options strategies. This is why it is one of our top Options picks listed in our free resource “Options HotList“.
Our Options Trading List
Apple is just one of the instruments we look at for trading stocks options. Mike here at Netpicks has really put his selection process down to a science when deciding which asset will be used when searching out an options play. Here is Mikes three point checklist he shared when asked how he determined his list of instruments:
- Liquid Options – I want to trade the products with the most actively traded options. This way I can get in and out quickly at good prices.
- Volatility – I’m looking for products that show a history of good movement back and forth. Ideally, I’m looking for quick moves so I can get in and out as soon as possible. A stock or ETF that only makes a few decent moves each year is not going to make the cut into my hot list.
- Diversification – It would be really easy for me to load up my entire list with tech names and call it a day. The tech sector tends to lead the market and has an endless number of quality names to trade. However, I would rather establish a broad list of names covering a number of different sectors (tech, energy, financial, index ETF’s are the big ones for me).
Options may not be right for every trader and the biggest reason we hear is that they seem too complicated. There are some strategies that are more in depth, like the ones where you can profit from limited price movement, but you can stick with simple calls and puts.
You don’t have to be a “jack of all Options strategies” to take advantage of a vehicle that has defined risk, strong use of leverage and can get you involved in high priced stock movements at a fraction of the cost. Your options trading can be a simple or as complex as you choose.
Can We Help You Get Started?
You’ve read this far which means options trading is something you are seriously considering either as your first trading venture or in addition to your current trading.
We want to help you.
You can have our list of stocks and ETF’s that have been consistent performers for us and others that we’ve introduced to options. Not only that, you will be invited to try out our popular Options Reversal Strategy for 3 weeks for free.
You can download your Hot List here and make sure you check your inbox for your Reversal System invitation.