Option Trading - Time is Money
Stock Trading Techniques | Stock Trading Methods | Trading using Ranges
Trading option is more complex than trading stocks. Options are popular because they offer traders a more flexible approach.
However, what should you do if you are certain something big is going to happen to the stock, but you don't know if its price is going to soar or plummet?
This is a situation in which you might want to consider trading stock options rather than the underlying stock.
That's right, you can buy options - straddle options in this case - so that you profit from volatility. Provided the stock price moves significantly, you make a profit regardless of whether the movement is up or down.
You can buy trade options using the same broker as you normally use to trade stocks.
Surely there must be a catch? A trade where you win whether a stock's price rises or falls just can't be possible.
Well, it really is possible but the catch is that options have a time limit. Your stock price must show the volatility you expect within a certain time, or you lose everything.
If you get the price volatility you expect, the percentage price movement of the option will be much greater than the underlying stock. In other words, options are a leveraged trading vehicle. Price swings in the underlying asset undergo a multiplier effect to give greater gains or losses than you would get from trading the stock itself.
The seller of an option determines its price using the stock's historic volatility, the expiry date of the option, and the seller's own view of the stock's prospects.
If you wish to give the stock a long time to show volatility, you need to pay extra for this. Time has a price.
Using options trading jargon, longer option expiry dates are more expensive because they allow a greater time period to hit the strike price. Option sellers (known as writers, because they write the terms of the option) often use mathematical models such as the Black-Scholes model to set option prices. In recent years the mathematical assumptions underlying the Black-Scholes model have been disputed. The dispute arises because Black-Scholes assumes prices will behave in a more predictably limited manner than they can in a real world with occasional catastrophic events.
Your potential profits from buying an option are unlimited. Your loss is limited to the money you pay for the option.
When you buy a call option, you buy the right to buy shares at the strike price. If you buy a put option you buy the right to sell shares at the strike price. In practice most option traders do not actually buy or sell the underlying asset. Their wins or losses are delivered by cash in their trading accounts.
Example
The Old Electric Key Company's stock is priced at $15. You think the price will reach $30 some time in the next six months. You have $10,000 available for a trade. If you trade the stock, you could profit by $10,000.
You notice that call options in The Old Electric Key Company cost $4 for the right to buy the stock for $15 in six month's time. You could buy 2500 options with your $10,000. If the price actually reaches $30, your 2500 options would be worth 2500 x ($30 - $15) = $37,500.
The leverage provided by the options delivers a higher profit than would be obtained trading the underlying stock. Similarly, if the stock falls in price, your losses would be magnified if you traded options rather than the stock itself.