Option Trading

Option trading has a wide spectrum of strategies running the gamut from simple 'buy and hold' to the most advanced use of technical analysis. You can setup positions that have directional bias or completely neutral on direction of underlying asset movement.

Options are a contract conferring the right to buy (call option trading) or sell (put option trading) some underlying instrument, such as a stock or commodity, at a predetermined price (strike price) on or before a preset date (expiration date). Option trading has slightly more risk than stock trading due to this expiration property.

Two types of options may be traded in the United States option trading markets. The so-called 'American' options can be exercised anytime before expiration, whereas 'European' options are exercised on the expiration date. Though the history of the terms may lie in geography, the association has been lost over time. American-style option trading usually involves stocks, bonds and commodities as the underlying asset. The European options are often written on indexes. Option trading strategies vary with these two types of options due to each one having its own pricing model.

Options officially expire on the Saturday after the third Friday of the contract's expiration month. Option trading is not available to the average investor on Saturday when the US exchanges are closed, making the effective expiration day the prior Friday.

With some basic terminology and mechanics out of the way, on to some basic option trading strategies.

Option trading involves one of two choices when you close the position. Since all have a set expiration date, you can keep the option until maturity or sell before then. (We'll consider American-style only, and for simplicity focus on stocks.)

Many option traders do in fact hold until maturity and then exercise the option to trade the underlying asset. Assume the buyer purchased a call option, with a strike price of $25, at $2 per option. (Typically, options contracts are on 100 share lots.) To purchase the stock the total investment is:

($2 + $25) x 100 = $2700 (Ignoring commissions.)

This option trading strategy makes sense provided the market price is anything above $27.

But suppose the investor speculates that the price has peaked prior to the option expiration date. If the price has risen above $27 but looks to be on the way down without recovering, selling now is preferred.

Option trading is not without risk. Suppose the market price is below the strike price and is continuing down, but the option is soon to expire. Under this circumstance, prudent option trading would require the sell of the option before the price goes even lower in order to curtail further loss. The option trader can, at least, minimize the loss by using it to offset capital gains taxes.

Another alternative in option trading is to simply let the contract expire. Unlike futures, there's no obligation to buy or sell the asset - only the right to do so. Depending on the option premium, strike price and current market price it may represent a smaller loss to just 'eat the premium' if it is below the automatic exercise level. Option trading requires you to learn the automatic exercise rules and how you manage the trade at expiration.

Observe that option trading, like stock trading, carries the usual uncertainties: prices can rise or fall by unknown amounts over unpredictable time frames. But, added to that is the fact that option trading includes an expiration date.

One consequence of that fact is: as time passes, the price of the option itself can change. How much they change is influenced by both the price of the underlying stock and the amount of time left on the option. This is what makes option trading slightly more risky than stock trading.

Spend the time to learn the characteristics of options and option trading strategies. This will give you the ability to leverage your money with option trading far beyond what is available when trading stocks.