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Option Trading Strategies

Option Trading Strategies: Now, welcome to the wonderful world of trading onlineonline option trading equity options. As with spread betting I am developing a separate site which will explain option trading strategies and equity options  in a great deal more detail, as it is impossible to get across all the concepts in one page. As with all my sites all the information will be free.

The purpose of this section is to give a basic introduction to the subject, and to explain one type of option and a simple application, which can be used within your option trading and investment portfolio. You may have heard that option trading is high risk, and indeed it is, for much the same reasons that spread betting is high risk. The instruments themselves are derivatives from the cash markets, and are highly geared. The market in the US is enormous and certainly the most advanced, with over 12,000 equity options available to trade, so you are never short of choice! The new options trading site has now been published.

Option Trading Strategies: Covered Calls

The technique I am going to teach you is called covered call writing, and the reason I discuss it is several fold. Firstly it is easy to understand for traders and investors who have come from a stock trading background. Secondly, it is a tool which can be used with both an existing portfolio of stocks or shares, or alternatively which can be implemented as you buy new stocks. Thirdly it is considered to be the lowest risk of all in option trading strategies. You will need to be approved by your stock broker to trade these, as there are strict rules in place to ensure that novice online traders do not 'fall through the net'. However, with the suggested 5 year plan ( or for experienced traders) this should not be a problem. The options we are going to discuss are called equity options, as they are derived from the equity ( stock/share ). As I mentioned before, the market in America is enormous, with over 12,000 equity options available to trade. In the UK it is just under 100 ( the blue chip shares mainly ) which can be rather limiting, nevertheless, they are a useful tool for developing an additional income from your portfolio.

OK, let's start with some definitions, and I will try to keep this as simple as possible ( not because you won't understand ) but because the terminology can be very confusing for new traders. It took me 6-9 months to get comfortable with this so don't expect to pick it up straight away.

Option Trading Strategies: Calls, Puts & Options

Call Option - A contract representing the right for a specified time to BUY a specified security at a specified price

Put Option - A contract representing the right for a specified time to SELL a specified security at a specified price

An Option - A contract which gives the buyer the right, but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date.

Right, let me try and explain. Suppose you are buying a classic second-hand car. You visit the owner, love the car, and agree a price, but explain that you will not have the cash for 4 weeks. The owner agrees to hold the car and the price for you for only 4 weeks, but on condition that you pay a small non - refundable premium for his trouble ( this is in addition to the full price of the car )

This is what an option contract is - the car owner has effectively written an options contract to give you, the contract holder, the right to buy the car within the four week period, at the agreed price. Now, ( this is important), as the option buyer ( or holder of the contract ) you have an option to buy, but you don't have to if you change your mind. Which is why in the above definition it says ' the right, but not the obligation' - if you change your mind you just walk away. All you have lost is your premium which the buyer keeps ( even if you do decide to go ahead ). The car owner, who has written the contract, has a contractual obligation to deliver the car at the agreed price, and he or she MUST deliver.

To summarise, as an options buyer, you have choices - you can exercise the contract or walk away, but as an options seller, you do not have any choices - if the contract is exercised you MUST deliver the asset.

I just want to take this example a stage further ( I know its not ideal but I hope it gives a feel for what these things are all about ). Let's assume that whilst you are waiting for the bank to supply the cash, so that you can go ahead and buy the car, the original factory where the cars were made is destroyed by fire. Suddenly these cars increase in value sharply. You, however, have a contract in writing at an agreed price, provided you buy within the next four weeks. Now, you as the buyer or holder of the contract have two choices :

You can exercise your contract by paying the seller the agreed price, and immediately put the car on the market and sell at a profit

You can sell your contract on to someone else as it now has a higher 'premium' value due to the increase in value of the underlying asset (the car )

Now, as the seller of the car ( the writer of the contract option )you have no idea who will exercise the contract, which could have been bought and sold many times over during the 4 week period. But one thing is constant. If it is exercised, you will HAVE to deliver the asset at the price agreed. It is a contract. This is how the options market works. Now lets look at some of the unique features of options;

Option Trading Strategies -Main Points Explained

Options have a specified contract life. Normally this is 4 weeks but there are options called LEAPS which extend for months and years.

As there is a specified time, this is a called a wasting asset. If you buy an option it will be worthless in 4 weeks if not exercised. Time works in favour of the seller, not the buyer!

Each has an agreed contract price fixed for the life of the option. This is based on the underlying asset ( the share).

The option carries a premium. This is paid to the seller of an option by the buyer and is always kept by the seller, irrespective of whether the contract is exercised, sold or expires worthless.

CALL options increase in value as the underlying asset increases.

PUT options increase as the underlying value of the asset decreases.

Below is a flow chart of what might happen to an options contractSchematic of option buyers and sellers over the period of its life. As you can see, the option seller has no idea who holds the contract at any one time, and the contract may be bought, sold or exercised at any time. Normally contracts are only exercised at or very close to the expiry date, but this is not always the case. Of course the option seller can always buy the contract back from the market, which will remove his or her obligation. Naturally where the option has increased in value, this will be at a higher cost than when sold,  thus incurring a loss for the option seller. At any time in the above, the option holder can exercise the contract and the option seller must deliver.

OK, lets just recap the above. When you buy an option the purchase price is called a PREMIUM. If you sell an option, the premium is the amount you receive. As a buyer you have rights, but no obligation. As a seller you have an obligation to deliver the terms of the contract. An option seller is also called a WRITER. Options are a derivative product, they are derived from something else. Equity options are derived from the equities market so the underlying asset is the share or stock price. The premium will vary minute by minute, up and down as the underlying value of the asset changes in the cash market. Options are leveraged instruments and therefore higher risk. Most equity options are 'Physical Delivery' which means that shares must change hands if the contract is exercised. Now one last point before we move on and it is simply this - as an option writer (seller ) you do of course have one choice - you can buy yourself out of the obligation by buying the contract back - this will naturally cost you more if the premium has increased in value! ( if the premium has decreased you may want to close out the contract for a small profit, or just leave it to expire for 100% profit on the premium )

As you can see from the above, the same option can be bought and sold many times before it is either exercised or expires worthless. Whatever happens, the option seller keeps the premium received from the initial buyer. As you can imagine all this trading has to be tightly controlled to ensure that buyers and sellers are matched correctly, and that contracts are fulfilled by sellers. In the UK, the options exchange is called LIFFE ( London International Financial Futures and Options Exchange ) and this is where all equity options are managed and traded. In the US there are several exchanges, but the principle ones are CBOE ( Chicago Board of Options Exchange ), AMEX ( American Stock and Options Exchange) and the Philadelphia Exchange.

Everything to do with trading, managing and exercising the options is conducted by the exchanges. You do not have to worry about actually doing anything - it all happens automatically. So if, for example, you have sold a call, and the contract is exercised, this will all happen automatically and the broker will transfer the shares out of your account at the agreed contract price and replace with cash. Finally there are two 'styles of options' - American style and European style. American style options can be exercised at any time as in our example above, whilst European can only be exercised only at expiry. Most equity Options will be American style but please check and make sure beforehand.

Now before we look at call writing in detail, we need to understand some of the basic terminology of options ( oh you thought we had already done that! )and also look at an option series. Please understand that this is just the basics. The new site covers all of this is detail, along with topics such as historic and implied volatility, the Greeks, the importance of time, and many different option strategies. I have published a separate site on one particular trading strategy which is the straddle option. On this page I am just trying to cover the basic terminology and concepts.

Definition Term

The strike price is the price at which the option contract has been written. As you will see in a minute, each equity option has a whole series of strike prices from which you choose the one you feel is the most appropriate.

Strike Price 

An option is 'in the money' if the strike price is below the market price for a call, and above the market price for a put. For example with a call if the strike price for LLoyds equity option was 500p and the equity was trading in the market at 550p, then the option would be 50p in the money. ( remember a call increases in value as the underlying asset increase in price ). With a put, this would be in the money for the same strike price if the equity was trading at 450p.

In the money

An option is at the money if the strike price and market price are the same.

At the money

This is simply the reverse of being in the money. For example with a call, if the strike price for a LLoyds equity option was 500p and the equity was trading in the market at 450p, then the option would be 50p out of the money. ( remember a call increases in value as the underlying asset increases in price ). With a put, this would be out of the  money for the same strike price if the equity was trading at 550p.

Out of the money

An option chain is a complete table of all the options available for that particular period and for that particular equity.

Option chain

An option has intrinsic value if it is in the money and is the difference between the strike price and the market price. An at the money or out of the money options therefore has no intrinsic value.

Intrinsic value

An option is a 'wasting' asset which has two components, an intrinsic value ( see above) and a time value. In an 'out of the money' option, the value of the option is all time value ( i.e. there is a chance that it could become an 'in the money' option ). In an in the money option it is a mixture of intrinsic value and time value. The time value element decreases exponentially ( faster ) as the expiry date draws closer until it falls to zero at expiry as there is no time left.  As a call writer time works in your favour wasting away the option faster and faster - for the buyer the converse is true with time working against them as there is less and less time for the option to move into the money. As an option holder I prefer to be a seller rather than a buyer as time works in your favour. This is a key part of call writing which we will look at in a moment.

Time value
Option Trading Strategies - Option Chain

OK - now lets look at an actual option chart and I will try to  explain the key elements - the one below is for Hilton Hotels, ticker HLT . We are looking at the July 06 contract. As you can see there are also contracts for Aug/Oct/Jan07 etc ( these are not shown here.) There are 30 days to expiry and the stock is trading at $27.10

Hilton Hotels - HLT : Expiration Month : July 2006
(Aug 06) (Sept 06) (Oct 06) (Jan 07) (Jan 08) (Jan 09)
Sym. Last Chg. Bid Ask Vol. O.I. Strike Sym. Last Chg. Bid Ask Vol. O.I.  
JULY 06  Calls 30 days to expiry HLT @ 27.10 JULY 06 Puts
HLTGW 8.90 0.00 9.40 9.80 0 14 17.50 HLTSW 0.20 0.00 0.00 0.05 0.00 15  
HLTGD 7.10 -0.50 6.90 7.30 12 76 20.00 HLTSD 0.35 0.00 0.00 0.05 0.00 67  
HLTGX 4.50 -0.10 4.50 4.80 10 3488 22.50 HLTSX 0.10 0.00 0.00 0.10 0.00 594  
HLTGE 2.20 0.00 2.30 2.45 204 4904 25.00 HLTSE 0.35 0.00 0.15 0.25 0.00 2073  
HLTGF 0.15 +0.05 0.05 0.15 110 3619 30.00 HLTSF 3.40 0.00 2.85 3.10 0.00 121  
HLTGG 0.05 0.00 0.00 0.05 0 50 35.00 HLTSG 8.90 0.00 7.80 8.20 0.00 0  
                               

OK - we are almost there !!!!!! As you will see the premiums being quoted have a bid and ask as in other markets. The OI column is the number of open contracts for this series and strike. So for the $25 call strike there are 4,904 open contracts at the moment. The Vol column is the number of new contracts today - lots of calls and no puts so everyone must think the market is going up! In the symbol column, each contract strike/period is identified by a code. The codes identify the option month and price and the share ticker appears first. These codes can be found on all option related web sites.

Finally, if we consider one of these - lets take the $25 strike price. The stock is trading at S27.10 and the call premium at the moment is being quoted $2.30- $2.45. Because this is an in the money option, $2.10 is intrinsic value and the remainder is time value ( 0.20-0.45$). There is 30 days left of the contract until expiry. Again expiry dates will be found in all good option web sites.

Now we have covered the basics of trading online equity options, I am going on to explain the very simple technique called covered call writing which is one of my favourite option trading strategies, which I hope will add additional income to your portfolio of investments.

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