Why Are Options So Popular?

Options trading allows a market trader many ways in which to profit. Whether a stock goes up, sideways or even down, there are options strategies that allow a trader to profit from any move. Add to this the cost of a typical option, to that of the cost of buying a stock and you can see that many investors who might not have been able to trade are now active in the marketplace. Risk is another factor playing into options trader’s minds. Although options are considered a riskier style of trading verse stocks, there is generally less capital at risk since the cost of buying an option can be only a fraction of the original cost of buying a stock.
The most basic of options is the simple, buy and sell a call or put. This is used as a low capital means of garnering a profit on market movement. Options can also be used as insurance policies in a wide variety of trading scenarios. You probably have insurance on your car or house because it is the responsible and safe thing to do. Options provide the same kind of safety net for trades and investments. They also increase your leverage by enabling you to control the shares of a specific stock without tying up a large amount of capital in your trading account.
Options can be used to offer protection from a decline in the market price of a long underlying stock or an increase in the market price of a short underlying stock. They can enable you to buy a stock at a lower price, sell a stock at a higher price, or create additional income against a long or short stock position. You can also use option strategies to profit from a move in the price of the underlying asset regardless of market direction.
There are three general market directions: market up, market down, and market sideways. It is important to assess potential market movement when you are placing a trade. If the market is going up, you can buy calls, sell puts or buy stocks. Do you have any other available choices? Yes, you can combine long and short options and underlying assets in a wide variety of strategies. These strategies limit your risk while taking advantage of market movement.
The following tables show the variety of options strategies that can be applied to profit on market movement, this is not a complete list but a good place to start. (click to enlarge)


Bullish Limited Risk StrategiesLearning more about the different uses of options can help you to boost your trading success. Understanding these different uses will give you the potential to beat the next person down the street or your sophisticated options market maker. You have a chance to look at different scenarios that they do not have the knowledge to construct. All you need to do is take one step above the next guy for you to start making money. Luckily the next person, typically, does not know how to trade creatively.

How Options Work (Part 1)

Options are the most versatile and fun trading instruments ever invented. Many traders don’t realize it but options have been around since the 1800’s. Since options typically cost less than stock, they can provide a leveraged approach to trading that can significantly limit the overall risk of a trade or simply provide additional income. Basically, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy or sell the underlying stock at a specified price before 4:00 PM Eastern on the 3rd Friday of their expiration month. There are two kinds of options: calls and puts. Call options give you the right to buy a stock and put options give you the right to sell a stock. You do not want to mix these two up. It will cost you many headaches and lost trading capital if you do.Margin on options trades can sometimes be quite complicated especially in the area of naked option writing. For simple call and put buying, there are no margin requirements since your risk is limited to the price of the option. For those selling options to open a position, you will have an obligation to buy a stock (if you sold a naked put) or deliver a stock (if you sold a naked call). Since it is possible that you will be required to buy or sell a stock when selling naked options, you will have to have some margin available in your account to start the trade. Your brokerage firm will let you know the exact amounts.To trade options, you will be required to learn a few more trading terms above those associated with plain stock transactions. We will start with a strike price, expiration date and option premium. The strike price – This is the price at which you are agreeing to strike the deal at. In other word the price you are trying to buy or sell a stock. These strike prices are the same for almost every Optionable stock. They begin at 5.00 and trade in 2.50 increments up to 25.00. 5.00, 7.50, 10.00, 12.50, 15.00, 17.50, 20.00, 22.50, 25.00. Above 25.00 and they start trading in 5.00 increments. 25.00, 30.00, 35.00… All options have a set amount of time before they expire. This is known as the expiration date. A stock option expires when the markets close on the 3rd Friday of the expiration month. If you purchased an option that expires in February then it will expire at the market close on the 3rd Friday of February. If you purchased an option that expires in March, then it will expire at the market close on the 3rd Friday of March. All listed options have options available for the current month, known as the front month, and the next month, front month + 1. This means that if we are in the February options month, front month, we will always have March options available since it is the front month + 1. You may want to buy a longer term option and look to see if there are any April options available for a stock you are trading in. If there are no April options available then it is because all Optionable stocks are assigned a trading cycle. Each stock has a corresponding cycle of months that they offer options in. There are three fixed expiration cycles available. Each cycle has a four-month interval:
A.
January, April, July and October
B.
February, May, August and November
C.
March, June, September and December
If a stock you are trying to write options on is traded in cycle B you can get options quotes for any of the months listed in cycle B at any time. If you wanted to buy or sell options for the month of April you would have to wait until the 3rd Friday of February was gone. At that point we would be in the options month of March. The March options month would be the front month. Options are written for all Optionable stocks on the front month + 1 (March + 1 = April).

How Options Work (Part 2)

How Options Work (Part 2)

Once you own an option, you have 3 different ways to exit it. You can exercise it, sell it, or let it expire worthless. By exercising an option you have purchased, you are choosing to fulfill the options contract. If you bought a call option and you exercise it you will be buying stock at the agreed upon price (Strike price). If you bought a put option and you exercise your put you will be selling stock at the agreed upon price (Strike Price). Only option buyers have the choice to exercise an option. Option sellers, on the other hand, are required to sell stock to a call option buyer who chooses to exercise their contract. Put option sellers are required to buy stock from put option buyers who wish to exercise their contracts.Selling your option, sometimes known as offsetting, is a method of reversing the original transaction to exit the trade. If you bought a call, you have to sell the call with the same strike price and expiration. If you sold a call, you have to buy a call with the same strike price and expiration. If you bought a put, you have to sell a put with the same strike price and expiration. If you sold a put you have to buy a put with the same strike price and expiration. Although you may not be selling your original option trade back to the same exchange, you will have an offsetting order as you account will show a buy and sell trade on the same stock, strike price and expiration month. If you do not offset your position, then you have not officially exited the trade.If an option has not been offset or exercised by expiration, the option expires worthless. If you originally sold an option, then you want it to expire worthless because you then get to keep the credit you received from the option premium without having to fulfill any part of the option contract. Since an option seller wants an option to expire worthless, the passage of time is an option seller's friend and an option buyer's enemy. For instance, If you sold a call on a stock in which you did not own, you would want the call to expire worthless so that you would not be required to sell someone stock that you do not own. You would like for the option to expire with the stock trading under the strike price of the option you sold. If you sold someone the right to buy a stock from you at 30.00 and the stock closed on expiration Friday at 28.00 you would not have to worry about someone exercising their options contract to call you out of the stock. If you bought an option, the premium is nonrefundable even if you let the option expire worthless. As an option gets closer to expiration, it decreases in value.It is important to note that most options traded on U.S. exchanges are American style options. These differ from European options in one main way. American style options can be exercised at any time up until expiration (4:00pm Eastern on the third Friday of the expiration month). In contrast, European style options can be exercised only on the day they expire. All the options of one type (put or call), which have the same underlying security, are called a class of options. For example, all the calls on IBM constitute an option class. All the options that are in one class and have the same strike price are called an option series. For example, all IBM calls with a strike price of 130 (and various expiration dates) constitute an option series.

COVERED CALLS

Covered Calls
Also known as a covered write. In the stock market the word write means to sell. Covered meaning you own what it is that you are trying to sell.
A stock/option strategy in which stock is purchased and a call option is sold against the stock you now own. This is a low risk/low profit strategy similar to selling out-of-the-money puts. This position is called a covered write since the short call is "covered" by owning the underlying stock. The short-term risk profile of this strategy is very similar to selling an uncovered put.
There are 2 risks involved in this type of trade. The first is that the stock you purchased could go to zero. So it is always a good idea to only buy quality stocks for this type of trade. Many traders will buy a stock for a covered call because it pays great premiums but the stock is not one that has good fundamentals and technicals. Remember the first part of placing a covered call trade is actually owning the stock. Make sure it is a good one that you would not mind owning.
The second risk is that you give up the potential profits f the stock moves up drastically. Before selling a call against stock you own, you should be willing to have your stock called away from you. This strategy can be used as a way to generate monthly income or just to add value to your portfolio. Some covered call writers use this strategy as a way of selling stock that they currently own or to capture income as their portfolio drops in value.

Suppose you own MU at 38.90 and you think it is going to drop in the next month or two. You like the stock and want to own it for the long run so you do not want to sell it. If you think the stock may drop to support at 35.00 in the next few weeks and don’t want to see your portfolio drop too much you may want to sell a call against your position in MU. If you own 300 shares you can sell the Aug 45.00 calls for 0.80. If you’re a bit of a risk taker then you can sell the Aug 42.50 calls for 1.50. If MU does drop and at expiration Friday the stock is trading at support of 35.00, you will have gained 0.80 per share as the stock went down.
MU $38.90

Strike Price Call Options Last Trade Bid Ask O.I.

01 Aug 35.00 (MU HG) 0 5.60 0 41

01 Aug 37.50 (MU HT) 5.10 4.00 50 1194

01 Aug 40.00 (MU HH) 4.40 2.80 0 1485

01 Aug 42.50 (MU HV) 1.85 1.75 5 2499

01 Aug 45.00 (MU HI) 1.90 1.05 0 2512

This may not seem like much but done month after month it can start to add up. The option buyer of your call you sold has the right to buy your 300 shares of MU at 45.00 per share. If MU is currently trading at 35.00 the option buyer will most likely let his option expire. You do nothing. On Monday morning you still own your 300 shares and own the 0.80 or 1.50 per share premium you received depending on which strike price you sold.
If you are bearish on the stock you may have even sold the Aug 37.50 call for 3.70 instead of the Aug 45’s. Depending on how bullish or bearish you are will tell you which strike price to sell. If on Expiration Friday MU is trading at 38.90 and you do not want to get called out of your position, you can always place a trade to buy back the Aug 37.50 calls you originally sold. At this point the option should be trading for the intrinsic value and you can buy the option back for 1.40, you sold it for 3.70 so you make an additional 2.30 per share as the stock goes sideways.
The initial margin for a covered write is the same as for long stock. The proceeds from the call sale may be used to offset the stock purchase. The proceeds from the sell of the call option you sold are available for you to withdraw from account the next trading day if you wish to remove them for personal use. Covered call writing is something that is often done in an IRA as many investors already have stock just sitting around waiting for some types of profits.