In today's ever changing markets, one wants to ensure that his investments will perform no matter what scenario the markets may bring. When trading only stocks or futures, this can sometimes be a difficult task to accomplish. However, option trading offers many solutions to such problems. Options are financial instruments that can provide the investor or trader with tremendous profit potential, limited risk, and the flexibility needed to take advantage of almost any investment situation one might encounter. Whether the market outlook is bullish, bearish, choppy, or quiet, option trading can significantly increase one's profitable trading opportunities.
On April 26, 1973, the Chicago Board Option Exchange (CBOE) opened its doors and began trading listed call options on 16 stocks. From that humble beginning, option trading has evolved to today's broad and active markets. The listing of options on an exchange standardized striking prices and expiration dates-and that standardization cleared the way for the growth that has followed.
Option trading can provide you with the incredible benefits of leverage, risk management, and tremendous profit potentially. And in today's uncertain markets, that's what most traders are looking for. Take what you've learned here and use it to explore option trading for the first time or further than you have already. It gives you many choices...it gives you many options. Find the ones that work best for your market objectives and see how they can help increase your bottom line.
Profit Graphs
Some traders prefer to see columns of numbers, and others-myself included-prefer to look at graphs or charts. A "profit graph" is a graph of the potential profits and losses from a position. With options, it is possible to describe most of the major strategies by the shape of their profit graphs.
Outright Option Buying
The outright purchase of an option is the simplest type of option trade for most traders to understand, and some prefer to go no further. When we say "outright," we are referring to an option purchase that is not hedged by anything else, such as the sale of a similar option or the sale of stock. In the preceding example, the purchase of the XYZ July 50 call for 3 has several definable qualities that are fairly easily understood by most traders. First, the cost of one option is $300, and that is the most that can be lost. Second, the breakeven point at expiration is 53 (plus commissions), for a call option is always worth at least the difference between the stock price (53) and the striking price (50). Third, nearly unlimited profits are available, for the option will appreciate in price as long as the underlying stock, XYZ, continues to rise in price.
This is typically felt to be an aggressive strategy, because the leverage is so high. You can lose all your money in a fairly short amount of time if the option expires worthless. In the preceding example, if the stock drops at all from the price of 50 (where it was trading when the option was purchased) by expiration, the option will expire worthless and the trader will lose the$300 he paid for the call. Leverage works both ways, of course, and thus huge percentages are possible as well, for example, if the stock were to advance by only 20 percent (from 50 to 60), then the option would be worth $1,000. So the stock trader would make 20 percent, while the option trader would make 233 percent ($300 becomes $1,000) from the same stock movement.
Of course, leverage is completely in control of the investor. One would not put his entire account into such an option purchase. But he might put 3% to 5% of his account into it. So, if the trade went back, he would have a 3% loss of his overall account value, say, but if it profited, he could make a strong return of 6% or more, when viewed from the perspective of his entire account value.
Using Long Options to Protect Stock
Another advantage of owning options is that they can be combined with stock or futures to produce a position that has much less risk than that of the underlying. Long puts can be bought as a hedge against the downside risk of owning stock, or long calls can be bought as a hedge against the risk of selling stock short. Buying Puts as an Insurance Policy for Long Stock If a trader wants to protect against the downside risk of owning stock, he can buy a put against that stock. The ownership of the put will eliminate much of the downside risk, while still leaving room for plenty of gains on the upside.
Buying Both a Put and a Call
In some cases, a trader may feel that there is the potential for explosive movement by an underling instrument, but he is uncertain of the direction that movement might take. In such a case, he might consider buying both a put and a call with the same strike-a straddle. Then, if there is a large move-either up or down-he will make money. The drawback, of course, is that nothing much happens and time decay eats away at both the put and the call. This strategy has profit potential as shown in Figure 2.4; the maximum loss, which is equal to the initial premium paid, would be realized if the stock were exactly at the striking price at expiration. However, the possible rewards are large if the stock rises or falls far enough by expiration.
As a general rule of thumb, this is a strategy that should only be undertaken if two conditions are met:
- The options are inexpensive on a historical basis
- The underlying has a history of being able to move distances large enough to make the straddle profitable
Markets have a tendency to trade in small increments most of the time, and then to make up most of their ground in a very short period of time. Studies have been done that show that 90 percent of the gains are made in only 10 percent of the trading days (other studies show similar figures for downside moves as well). It is often the case that options get very cheap just before large moves. This is especially true if the market has been rather trendless for a while just before a big move occurs; option buyers are losing money to time decay and therefore are less aggressive in their bids for options, while option sellers become more aggressive as their profits build up. There have been many examples of options getting "cheap" just prior to large market explosions. One of the most famous was the cheapness of index options just prior to the crash of 1987, but there are many other instances as well, both in stocks and in futures.
Selling Options
Just as with any other type of security, the initial, or opening, transaction may be a sale rather than a purchase. When you do that with a stock, you must first borrow the shares before you can sell them "short." However, with options or futures, that is not necessary. The mere option transaction itself creates a contract, so that the buyer of the option is long the contract and the seller of the option is short the contract. The common term to describe the sale of an option as an opening transaction is to say the option has been written. This term comes from the old days when a physical contract was issued by the seller and delivered to the buyer.
In today's paperless trading world, there is no longer any physical contract, but the term remains.
Summary
The broad overviews of the various strategies expressed in this chapter should be enough of a foundation for understanding the basic principles of option trading. It was not our intention to detail the explicit calculations of breakeven points and explain follow up actions for these strategies. What we hope you come away with is a preliminary groundwork by which you can either begin trading options, or continue trading options in a more efficient and effective way.
Option trading can provide you with the incredible benefits of leverage, risk management, and tremendous profit potentially. And in today's uncertain markets, that's what most traders are looking for. Take what you've learned here and use it to explore option trading for the first time or further than you have already. It gives you many choices...it gives you many options. Find the ones that work best for your market objectives and see how they can help increase your bottom line.
Autor: Lawrence G. McMillan
More information at SlipStreamWealth.com
Professional trader Lawrence G. McMillan is perhaps best known as the author of Options As a Strategic Investment, the best-selling work on stock and index options strategies, which has sold over 200,000 copies. An active trader of his own account, he also manages option-oriented accounts for certain individuals. In a research capacity, he edits and contributes to his firm's publications: Daily Volume Alerts, The Option Strategist and The Daily Strategist-derivative products newsletters covering equity, index, and futures options. In these capacities, he is the President of McMillan Analysis Corporation, which he founded in 1991. Prior to founding his own firm, Mr. McMillan was a proprietary trader at two major brokerage firms-primarily Thomson McKinnon Securities, where he ran the Equity Arbitrage Department for nine years.
Added: January 3, 2010
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