Many people are intimidated by the notion of trading options, fearing that they need to be rocket scientists in order to understand them. There's no need to be intimidated, because with the right mentor, the basics are easy to understand. This article covers the basics of options trading.
- Understand the basics of what an option is:
- An option is the right - but not the obligation - to buy (Call) or sell (Put) a stock's index or future at a specific (strike) price before a specified amount of time (expiry date).
Understand how options work:
- There are several benefits to buying stock options as opposed to buying the stock outright. They are relatively inexpensive, particularly when compared to the cost of the underlying instrument. For instance, you might be able to buy stock in XYX Corp. for $1000 per share. Stock is commonly traded in blocks of 100, so you would spend $10,000 for this position.
You can control the same amount of stock for a fraction for that price by buying an option instead. The options might be listed for 8 points. So by purchasing options, you will spend $800 instead of $10,000 to control 100 shares. (Stock options are for 100 shares, so $8 X 100 shares gives you the price of $800, not including your commission.)
Keep in mind, you are NOT buying stock, you are leasing its profit potential for a given amount of time.
Options have a time value that decreases the longer you own it.
Learn the difference between puts and calls.
- Call options give buyers the right to buy a set amount of an underlying instrument (usually 100 shares per contract) at a specified price (the strike price) within a set time (prior to expiration).
Put options give buyers the right to sell a set amount of an underlying instrument (usually 100 shares per contract) at a specified price (the strike price) within a set time (prior to expiration).
Determine a stock that you want to trade, and what direction it's going in, whether that be up, down, or sideways. Many people prefer to use index ETFs (such as SPY or QQQ) since they are less volatile and will be more consistent.
Draw your support or resistance lines using your charting software. Use indicators (MACD, RSI, Stochastic, etc) to determine stock direction. In this example, the stock is headed lower due to a crossing in stochastics and a double top pattern.
Choose either a bear call spread or a bull put spread (see tips). A bear call spread will be placed above resistance. A bull put spread will be placed below support. The goal of the spread is for the stock to stay neutral or bearish when placing a bear call spread (BCS), or for the stock to stay neutral or bullish when placing a bull put spread (BPS).
Determine what price to set your spread at. This should be above resistance for a BCS or below support for a BPS. In the above example, placing a BCS at $135/136 is perfect. If your stock has dollar options, it's advised to place more contracts with a less spread (10 contracts $135 / 136) vs doing less contracts with a larger spread (5 contracts $135 / 137).
Calculate your profit/loss potential by using your brokerage's tools or by hand. As a rule of thumb, your risk is your spread difference ($136-135) multiplied by 100. Then subtract your profit. For example, if you receive $30 for a $135/136 BCS, your risk is $100-30 = $70. And your ROI would be $30/$70 = 42%. Make sure your profit is enough to justify the risk. Additionally you can use probability calculators to see break even points and danger zones. Stick with a certain probability of success and don't break that just to get a better profit.
Place the spread by selling the option that's closer to the stock price and buying the next closest. For example, for a BCS, sell the $135 call and buy the $136 call. For a BPS, sell a $120 put and buy the $119 put.
Set your stop losses above the resistance or below the support. Follow up with the trade every day to see if the stock is going against you. If it stays still or goes in the desired direction you have to do nothing, just let it expire. If it goes go against you, you can buy the sold option back (for a loss) and let the bought option gain value, hopefully breaking even or even making a small profit. Also feel free to close the trade out at any time if you've made a profit and want to keep it.
- A spread above the current price is called a bear call spread (BCS for short). A spread below the price is called a bull put spread (BPS).
Don't get upset if a trade goes against you. It happens! Just learn what went wrong and move onto the next trade. Don't "double up" next month because of it.
Use a brokerage with low commissions to maximize profit.
This is a very broad overview, please consult additional reference materials before conducting this trade.
- Options are not suitable for all investors. They carry with them a lot of risk and responsibility. It is possible to lose more than you have in your account!
Always have an exit strategy, your trades should be automated and rule-based, not emotion based.
- A brokerage account with options level trading enabled.
A charting software (such as Trade Navigator) and a data plan.
Article provided by wikiHow, a wiki how-to manual. Please edit this article and find author credits at the original wikiHow article on How to Invest in Options. All content on wikiHow can be shared under a Creative Commons license.
No comments:
Post a Comment