Stock Options and Trading Systems
Stock options are derivative securities that derive their value from the prices of the underlying stocks. Options allow traders to leverage the price changes of the stocks, possibly generating larger profits than from owning the stock directly. The large number of available option contracts on an individual stock allows the use of a wide range of trading strategies.
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Overview of Options
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Stock options come in two forms--puts and calls. A call option gives the option holder the right to buy the underlying stock at a specific price, called the strike price, until a specified expiration date. Call options increase in value if the stock price rises. Put options give the holder the right to sell the stock at the strike price until the expiration date. Puts increase in value when the stock price falls. Option sellers collect the premiums for the contracts and must deliver the stock if a call option is exercised or buy the stock if a put option is exercised.
Trading Candidate Systems
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One approach to stock option trading systems is to find stock candidates with the potential for large price moves either up or down. The trader can buy call options if the stock is predicted to rise or put options if the price is forecast to drop. A trader can use stock screening software and develop a set of criteria to screen the universe of stocks looking for trading candidates. Another way to use this type of system is to subscribe to a service that provides candidate stocks for potential large price changes.
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Strategy Selection Systems
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Option traders have developed over 20 strategies to profit from stock price moves or even no price movement. These strategies use combinations of option contracts with different strike prices and/or expiration dates. A trader using a strategy selection system attempts to predict the future price movement of a particular stock and apply the option trading strategy that will profit from that price movement. This type of system is used specifically for option trading and avoids searching through thousands of stocks for trading possibilities.
Option Complexities
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Option trading systems can range from the simple purchase of call or put options based on a price forecast to complex strategies that attempt to capture the time value and volatility fluctuations of the option contracts. The underlying factor is that options are complex when compared with stock or even futures trading. Traders looking for a system must understand the function of the contracts, how a broker handles option trading and all the possible outcomes of a particular option trade.
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