Although most of my posts deal with the art of Day trading or Swing trading, I have been asked by many to include information for those of you interested in trading options. Holding a series 4 license, I am qualified to discuss this type of trading but will do so in an informational capacity only. A primer to options trading so to speak. The Series 4 license is for managers supervising options sales personnel or supervising compliance for a FINRA brokerage firm. Now let’s start at the beginning.
What are options and what do they let us do? Options give the investor flexibility to put together a strategy or series of strategies to achieve a specific investment objective. Options give the investor leverage. It allows him or her to control more shares of a stock for less capital outlay. In general, one option contract will represent 100 shares of a specific stock. If you bought 100 shares of stock XYZ trading at 25 dollars a share your capital outlay would be $2500. If you bought one option contract on the same stock you may only be paying a $2.50 premium and a cash outlay of $250 to control the same number of shares (1 contract = 100 shares x $2.50 = $250). So if you purchased a call option (the right to buy 100 shares of stock) you can control the same number of shares of XYZ stock until the specified expiration time of that option. REMEMBER: unlike purchasing a stock, if the option contract expires unexercised, you will lose the entire premium, in this case $250 dollars.
Purchasing options allows the investor to trade with added leverage. Because we are controlling the same number of shares as if we purchased the stock itself with about 10% of the capital.
Many investors, especially those who rely on income derived from their investments can also trade options to increase that income on a semi regular basis. If an investor owns shares of XYZ stock already, he can write (sell) calls against the stock he owns (this is known as covered call writing) and if the options expire unexercised the investor keeps the premium. This is relatively safe as opposed to naked call writing which has unlimited risk the same as selling short.
Depending upon the view of the investor as to the future direction of the stock and general economy, the investor can employ numerous strategies to take advantage of movements and fluctuations. Various combinations of buying and selling puts ( the right to sell a stock) and calls (the right to buy a stock) can allow the investor to profit from the numerous factors that cause stocks to fluctuate.
Options can also give the investor some protection from risk. The proper combination of owning stock, selling and buying options and the direction of the market can often not only minimize risk, but eliminate it altogether. With any type of investment there is risk, options can minimize risk, or be extremely risky instruments. They are complex investments and require a great understanding of what they are, how to use them and especially what the ultimate investment objective is.