Options for Trading Techniques
For many years, stock options have given traders another way to earn profits. While they are used primarily by intermediate and advanced investors, they have some nice advantages over buying stocks. A stock option gives its holder the option to buy 100 shares of a given stock at a given price by a certain date.
One big advantage of buying options is that they are less costly than buying stocks. Buying 100 shares of a stock may cost thousands, whereas an option may only cost a few hundred dollars. The second advantage of options is that they limit risk. A trader can only lose the cost of the option regardless of what a stock's price does, unlike the holder of the stock itself. Finally, options allow a trader to profit in any market.
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The Elements of an Option
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Every option has a strike price, which is the price at which the option holder can buy the stock when exercised. If the stock price is lower than the strike price, then the option is "out of the money" and has no market value. If the stock price is higher than the strike price, then the option is "in the money" and has market value that can be exercised. If the stock price and the strike price are about the same, then the option is "at the money." Each option also has an expiration month, and will expire the third Friday of that month.
Generally speaking, options that are closer to expiration are less valuable than those that are further away from their expiration dates. Likewise, options that are deeper in the money are more valuable than those that are out of the money.
Vertical Call Option Spreads
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One way that a stock trader can use options is by employing spreads. One of the most basic spreads is known as a vertical call option spread.
A vertical call option spread is where a trader buys an option that is at or in the money, and then sells an option that is at least one strike price higher than the one that was purchased. The risk of this trade has been reduced by the money received from the sold option, the potential profit is the difference between the two strike prices.
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Calendar Call Option Spreads
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Another type of option spread is known as the calendar call option spread. The first leg of this spread is constructed by purchasing a call option that is several months away from expiration. The calendar spread is completed by selling a call option that is close to expiration.
Learning How To Use Spreads
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The key to earning a consistent profit with these option spreads is by constantly managing and adjusting them. It must be realized that the optimal condition for these spreads occurs when the options sold expire worthless while the options that were purchased finish in the money yielding some market value.
Also, the purchased options must never be sold without first liquidating the option positions that were sold. Otherwise, the trader would be exposed to unlimited risk if the sold options were exercised against him.
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References
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