Option Strangle Magic » Stock Options

Options Trading and Risk

admin — Sun, 03 Jan 2010 10:36:12 +0000

Is options trading risky? This is one of the most popular questions that options trading beginners ask. In fact, my clients ask me this same question all the time. I would then ask them “What do you mean by risky?”. The usual answer would be “Can I lose a lot of money in options trading?”.
At least this brings us somewhere. Asking if options trading is risky without a clear idea what risk is in the first place gets nobody anywhere.
Risk is defined in many different ways to different people and for most people, risk is simply an expression of their fear of losing money. Whenever I am asked by an options trading beginner if options is risky, I know what they are really telling me is that they don’t want to lose money. How can we address this “risk” then?
Even though there are many ways to define risk in the financial sense, I think my 2 parts explanation caters best to the needs of the common retail investor. In my 2 parts explanation, risk in options trading for common retail investors are made up of; 1, Probability of Loss. 2, Consequence of Loss.
It’s like crossing a street. The probability of death is small but the consequence of death is catastrophic. However, because the probability is so small, we continue to do it every day.
In stock trading, you cannot really control the probability of loss because you win only if the stock goes up. That is why stock traders reduce the consequence of loss by having sensible stop loss in place.
See how the probability of risk and the consequence of risk interact with each other now?
The good news about Options Trading is that you get to control both the probability of risk and the consequence of risk! If you can control both elements of risk, won’t options trading actually be less risky than stock trading?
Options trading reduces the probability of risk through options strategies that profit from more than one direction. In fact, there are options strategies that profit when the stock goes up, down and sideways all at once! When you can profit in so many different directions all at once, won’t your probability of risk be dramatically reduced? An example of such an options strategy is the Call Ratio Spread which makes a profit if the stock goes up to a certain limit, stay stagnant or go down endlessly.
Options trading (http://www.optiontradingpedia.com) reduces the consequence of risk through leverage. Leverage cuts both ways. If you abuse leverage and buy options like you buy stocks, then you are in big trouble. However, if you use only money you can afford to lose in each options trade and make use of its leverage to produce the same returns that you would if you have bought the stocks instead, won’t the consequence of risk always be within your acceptable limit? An example of this is the Fiduciary Call options trading strategy.
Since the probability of risk and the consequence of risk can be dramatically lower in options trading than in stock trading, is options trading still “risky”?
Risk can be defined in many ways and options trading is inherently risky due to its nature as a leveraged derivative instrument. However, with sensible control of the probability and consequence of risk, your options trading experience may be a lot less “risky” than you think. Options trading becomes “risky” when you lose control over these 2 critical elements.

Why Most People Fail at Options Trading

admin — Fri, 01 Jan 2010 21:32:55 +0000

Have you or your friends ever attended an options seminar, learned how “simple” it is to make a high income from options trading but yet when you did it for real, you failed to make any money consistently?
Indeed, from my observation in this industry over the past decade, I have noticed that the chances of success for beginner options traders are extremely slim. In options trading, as in everything else in life, only a very small percentage of people make money consistently from options trading. This is true even amongst beginners who attended the same options courses. Yes, even with participants of the same options course, some will actually make some really good profit from options trading while most will not. What went wrong?
I explored the reasons for failure at options trading and narrowed it down to two main reasons; 1. Lack of a proven and systematic approach which novices to finance and economics can follow and trade with. 2, Lack of a robust trading mentality.
Let’s admit it, most beginner options traders are no professionals. In fact, most of them don’t even have a background in finance nor economics and don’t understand why things happen the way they do in the stock market or the economy. For such beginners, learning to pick stocks and analyze trades can be a disastrous attempt due to their lack of complete knowledge. This is where a lot of beginners fail. In fact, trading discretionarily by picking stocks based on a bunch of theories that may not work together in the first place or pure gut feel is a disaster even for professionals. In order for beginners to become consistent in options trading, a robust, complete and objective trading system and framework which has every angle covered needs to be introduced such that all they need to do is follow rules and make very limited subjective decisions nor analysis. Such a framework must include an objective method of identifying potential trading opportunities, objective method of identifying the correct options to trade with in order to optimize the risk/reward of the trade, an objective method of determining if an entry should be made as well as objective profit taking and stop loss policies. Without an objective and proven system and framework, no non-professional options trading beginners can hope to generate any consistent return.
Now, having that kind of “designed for beginners” trading system is merely the foundation of success in options trading. What really determines long term success is the trading mentality of the traders themselves. What’s the use of a trading system when the trader is incapable of following rules? Indeed, there are many options trading beginners who has made such losses in the past that they are generally ruled by fear and emotion to the extend that they are unable to follow rules at all. When the methodology they are following requires them to make an entry when a stock breaks out, a voice in their heads will stop them from buying saying that the stock might just drop back down. Then they will watch the stock continue upwards until it’s too late to make an entry.
There is a certain psychological profile needed of successful options traders and that includes the ability to listen to and follow the rules of their chosen trading system and methodology no matter how their emotions are firing up. They also need the ability to detach themselves from the money they are trading, just like a doctor’s detachment to the cries of their patients. A strong trading mentality comes not by nature. It is something that can be trained. Great options traders takes care of the way they run their life in generally and focuses on stress reduction and proper rest in the way their daily routine are run. Conversely, there are also traders who have been through so much pain in the stock market that they are generally unable to control their emotions and trade in a disciplined manner anymore. Yes, sadly, there are people who should just stay away from options trading.
Chances are good that an options trading system that is suitable for beginners (http://startradingsystem.mastersoequity.com) can be found. It is the trading mentality that most beginners don’t possess. In fact, in my observation, only about 1 in 10 people have what it takes to make it in options trading psychologically. The rest are fearful; fear of losing money, fear of their overall financial condition. It is exactly these fears that spoils trades and takes them deeper into their conditions.
Are there any solutions to the psychological issues of options trading?
The only way for most beginner options traders to become successful is to go through an extensive paper trading mentoring program over a significant period of time. Paper trading helps builds confidence if the trading system is good and over time convinces the trader that the system makes better decisions consistently than they can. Only when such faith is built can the options trader find the faith to follow their rules to the letter. Such period of training could take 6 months to a year. Sadly, most options trading courses are one weekend long these days. Real money triggers emotions which spoils trades if faith in the trading system has not been built up over a period of paper trading.
Options trading is like racing an F1 car. There is no short cut. Competence and proficiency needs to be built up over a significant length of training without which no secret formula can hope to work.

What Is Options Trading?

admin — Mon, 28 Dec 2009 20:58:40 +0000

An option contract is an agreement between two parties to buy/sell an asset (In this case, the asset refers to stock) at a certain price and specific date.
It is called an option because the buyer is not obliged to carry out the transaction. If, over the life of the contract, the asset value decreases, the buyer can simply elect not to exercise his/her right to buy/sell the asset.
There are two types of option contracts – Call options and Put options. A Call option gives the buyer the right to buy the underlying asset, while a Put option gives the buyer the right to sell the underlying asset.
A simple example: Peter buys a Call option contract from Sarah. The contract states that Peter will buy 100 Microsoft shares from Sarah on the 5th May for $25. The current share price for Microsoft is $30.
Note: this is an example of a Call option as it gives Peter the right to buy the underlying asset.
If the share price of Microsoft is trading above $25 on the 5th May, then Peter will exercise the option and Sarah will have to sell him Microsoft shares for $25. With Microsoft trading anywhere above $25 Peter can make an instant profit by taking the shares from Sarah at the agreed price of $25 and then selling the shares on the open market for whatever the current share price is and making a profit.
The $25 value, which is stated in the agreement, is referred to as the Exercise (or Strike) Price. This is the price at which the asset will be exchanged.
The date (in this case 5th May) is known as the Expiry (or Maturity) Date. This date is the deadline for the option contract. At this date, the option buyer is to decide if a transaction of the underlying asset is to occur.
Outcomes: Let’s imagine that at the expiration date, Microsoft is trading at $30, then Peter will buy the shares from Sarah at the agreed $25 and then he can sell them back on the open market for $30 and make an instant $5.
Alternatively, if Microsoft is trading at $20, then buying the shares from Sarah at $25 is too expensive as he can buy them on the open market for $20 and save $5. In this situation, Peter would choose not to exercise his right to buy the shares and let the options contract expire worthless. His only loss would be the amount that he paid to Sarah when he bought the contract, which is called the Option Premium – more on that a little later. Sarah would, however, keep the option premium received from Peter as her profit.
All in all, there are more than 50 strategies you can deploy in options trading by combining many different strike prices and expiration. But do you need to know all?
The good news is you do not have to!In fact, most of them allow you to make money very slowly or limited.

3 Trading Horizons Of Options Trading

admin — Thu, 24 Dec 2009 10:20:19 +0000

Have you ever lost money trading stock options?
Chances are good that you tried to apply the 3 trading horizons of stock trading to options trading and then got yourself hurt real bad.
There are 3 time horizons or what we call trading horizons in stock trading and they are; Long Term, Mid Term and Short Term. Long term horizon in stock trading means the buying and holding of stocks for 3 to 5 years, or sometimes longer. This is ideal for value investing in the long term prospects of a company. Mid term investing in stock trading is the buying and holding of stocks for 6 months to a year or two. Most stock investors use a mid term view to invest in new growth stocks which are expected to perform well in the immediate year. Short term investing in stock trading is the buying and holding of stocks for 3 to 6 months. These are stocks of companies that are expected to make a breakthrough in their industries. However, do these notions of investing apply in options trading? Not at all!
The truth is this: Stock Options are derivative instruments that have very short contractual lives! In fact, the longest expiration for exchange traded stock options rarely exceed 1 year! On top of that, the extrinsic value, or what we call time value, built into every stock options contract decays as expiration draws nearer, diminishing the value of your options even if the underlying stock remain stagnant. Due to these characteristics, stock options are trading instruments, not investing instruments, and have much shorter trading horizons than if you trade stocks. This is also why options trading is associated so closely with technical analysis these days because technical analysis is extremely useful in identifying short term trends or reversal of trends.
So, how is the long term, mid term and short term trading horizon defined for options trading?
In Options Trading, long term horizon is the buying of options with expiration of up to 1 year in order to speculate a long term rally or ditch in the underlying stock. Typically, long term charts on monthly time periods are used to identify such trends. Mid term horizon is the buying and holding of monthly options all the way to their expiration, each trade lasting no more than a month. Charts on weekly time periods are particularly useful for identifying mid term trading opportunities. Short term horizon lasts from 3 to 15 days in order to speculate a quick short term surge or ditch in the underlying stock and typically uses short term daily time period charts to identify trading opportunities.
From the above definitions, it is clear that stock options, as a short term trading or hedging instrument, is useless for anyone who is investing in the long term horizon defined for stock trading. Therefore, before you decide to completely replace your stock investing with options trading, first decide if trading stock options allow you to trade the way you always have with stocks. If it doesn’t, it is time for you to either stick with stock investing or learn a trading system which is perfectly suited for options trading.

Naked Option Writing â the Cadillac of All Option Trading Strategies

admin — Wed, 16 Dec 2009 23:46:26 +0000

Letâs be clear on this. There is no other option trading strategy that can outshine or even equal the profit generating potential of the sport of writing naked options. The term âsportâ is used here because those who practice this money making trading technique not only turn out fabulous profits but also have fun in the process. It is a fun, profitable but dangerous option trading sport that is mostly played by seasoned and skilled option players. That is, until the sportâs perilâs were tamed with the use of trading techniques that, while offering substantial safeguards to the player, still continued to offer high profitability ratios, albeit at slightly reduced rates. Having made it âinvestor safeâ has only slightly altered the profit potential of writing nakeds and certainly, without doubt, continues to be the premiere money making trading strategy in the options market.

The birth of the options market in recent decades spawned the creation of dozens of trading strategies and systems that is today being used not only by individual options traders but also by financial institutions. Stock options as an investment instrument is now widely employed as a safe and sound money strategy. The ability of options to give the investor a wide range of choices in stock market investment is what has made the options market grow by leaps and bounds over the last two or three decades. There are dozens of option trading systems being employed by individual investors as well as financial institutions. Each system is designed to accomplish a specific investment goal. A financial institution may use long put options to hedge its winnings in stocks that have appreciated in value, another investor may buy call options instead of stocks to enter a position in a security that has caught his fancy. Still another may sell calls against his stock holdings to generate income from his stock position, or what is now popularly known as covered call writing.

Trading strategies, techniques and systems available to the option trader are so numerous today that it would take a whole book to describe each and that would be just a brief description not a detailed explanation. It would be far beyond the scope of what we could cover in this short article. Most of the strategies are based on the principle of buying calls and puts or, variations of this strategy such as the use of spreads. The reason for the popularity of buying calls and puts and its variations is quite simple; limited or defined loss against the potential for unlimited and fabulous profits. This is what has driven thousands into the options trading game. But like everything else in life there is always a trade off. While the potential for fabulous profits against limited investment exists the reality of achieving such success is restricted. Itâs almost like buying a lottery ticket with the potential for winning fabulous riches. Or putting it differently, itâs also akin to going to a casino and placing bets on gaming tables with the hope that at the end of the evening you will come out with more money than you came in. As we all know there are very few winners in casinos and that is why the gaming business offers tremendous profits for the operators.

But one can be an option trader and be in a similar position as the casino operator. Â How? By being an option writer or seller instead of a buyer. For every option that is bought in the market, there must be a seller or writer of the option. These writers are the casinos in the options business. As the option seller you take the bets from the option buyers and since 75 to 80 percent of all options in the market expire worthless, you the seller pocket the premiums paid by the buyers when the options they bought expire worthless. For the benefit of those who are not familiar with gambling casinos, the winning odds of casinos over the betting player is only around 5 percent and yet they rake in profits from this business. Now imagine this, research and studies have shown that the option writer (seller) has better than 10 to 20 percent odds over the option buyer.

Option traders who successfully use the strategy of selling options consider themselves as having found the Holy Grail of Investments. And of all the variations in option selling strategies (just as many as there are in option buying), writing naked options is considered to be the Cadillac division. No other option selling system offers the profit potential of the naked writer.

So why arenât there more option writers in the market? For two reasons:

It must be noted however, that option writing is fast gaining popularity among serious investors looking to grow their wealth at a steady, consistent and secure manner regardless of market or economic conditions. For those willing to venture into this lucrative field for long term capital appreciation donât let the first reason above frighten you into inaction. There are many ways one can protect himself and conquer the element of âunlimited lossâ in writing nakeds. The author of this article is one of many successful naked option sellers. He has put out an e-book detailing a trading system that uses a three pronged strategy that trounces the so-called risk of loss to be almost neglible. Information about his system can be found at his web site.Â Â Â

Balance of Risk and Reward in Options Trading

admin — Mon, 14 Dec 2009 09:44:37 +0000

You don’t need to be a trader or an investor to know that the higher the risk, the greater the reward. This concept is true in all aspects of life and business. The more risk you are willing to undertake in life, the more life returns to you. Indeed, risk and reward are directly proportional and often in trading and investment, the more risk your account is exposed to, the greater the return on investment when things work out as planned.
Knowing that risk and reward are proportional makes finding the correct balance of risk and reward extremely important to all kinds of traders; stock traders, futures traders, options traders etc. There is no one solution that works for everyone and the correct balance is decided upon the risk appetite and risk tolerance of the individual trader.
For stock traders, balancing risk and reward primarily involves adjusting the amount of growth stocks and defensive stocks in one’s portfolio. Generally, the more growth or speculative stocks in one’s portfolio, the greater the risk due to greater uncertainty and therefore the higher the gain when things works out as expected. The more defensive stocks in one’s portfolio, the more predictable returns become and therefore the lower the return as these stocks does not generally move a lot. This degree of risk / reward balancing is at best crude compared to the surgically fine degree of balancing you can have in options trading.
Stock options are the most versatile trading instrument in the world right now due to the wide array of options strategies that are employable. Yes, not only can risk and reward be balanced through employing different mix of strategies in your portfolio, there are also different risk and reward profiles achievable by each individual options strategy. There are options strategies that range from making over 1000% profit while risking all your money to options strategies that make a mere 0.01% return while risking nothing as well as every centimeters in between.
As long as you understand what your personal risk appetite and risk tolerance is, you will be able to find an options strategy that suits your needs 100%. Here’s a general outline of the kind of risk reward balance that can be achieved through options trading:
Highest Risk, Highest Reward – OTM Call / Put buying
This is the options strategy that produces the legendary 1000% profit that amazed so many beginners. What those ads did not tell you is that the risk is losing ALL the money that you put into the strategy. This options strategy involves buying out of the money(http://www.optiontradingpedia.com/out_of_the_money_options.htm)call options when you think a stock is going to go up or buying out of the money put options when you think a stock is going to go down. Professionals use this options strategy with only a very small portion of their money in order to place a bet on an uncertain event such as leveraged buyout. Some lucky amateurs use this options strategy with all their money and then become millionaires overnight. The downside of this strategy is the fact that if the stock did not move far enough in the direction you expected it to, you can lose all the money you put into the strategy. That is also why so many beginners break their accounts overnight in options trading.
Various Degrees of Risk and Reward – Options Spreads
There are literally hundreds of possible options spread strategies out there with various degrees of risk and reward for every market condition. There are more aggressive bullish, bearish, neutral and volatile spreads and there are more conservative ones. All of them shares the same logic of higher risk compensated with a higher profit potential.
Lowest Risk, Lowest Reward – Options Arbitrage
Yes, there are literally risk free trading opportunities in options trading which also returns very small, sometimes negligible returns. These are the legendary options arbitrage strategies. Options arbitrage strategies such as conversion/reversal aims to make a fixed return totally risk free through simultaneously buying the underlying and shorting the overpriced synthetic equal or vice versa. The problem with such strategies is that the returns are so low that most of the time, it’s even lower than the commissions you will pay for the trades made. Even if you manage to return a positive return, the return can be as low as 0.01% in percentage terms. That is why arbitrageurs aim to make an absolute return using enormous amounts of money.
With this in mind, the most conservative traders may choose to specialize totally in arbitrage strategies (http://www.optiontradingpedia.com/options_arbitrage.htm) while the most aggressive traders may choose to specialize in leveraged speculation using OTM options. Everyone else would be able to find something to suit your risk appetite in the hundreds of spread possibilities. This degree of flexibility and range of risk/reward possibilities makes stock options the most versatile trading instrument in the world today and why options trading (http://www.optiontradingpedia.com) is so popular these days.

The Golden Rule Of Stock Options Trading

admin — Fri, 11 Dec 2009 21:26:44 +0000

Have you ever lost all your money in Stock Options trading?
If you are like most of us, then you might have lost an entire trading account just trading stock options before. No matter how hard you try, you seem to always lose all your money eventually even if you made some initial profits. Why is that so?
The truth is, stock options trading is risky business! Why is it risky business? Stock options trading is risky because you could lose all your money on any stock options trade if the stock eventually close with the options out of the money during expiration! Yes, even stocks that seem to be rising very quickly and steadily could take sudden and unexpected drops near expiration, taking your in the money call options way out of the money before you can react to it! This means that no matter how certain you are in stock options trading, there is always the possibility of a total loss. Stock options are fantastic leverage instruments but if you simply throw all your money into every trade and hope to strike lottery, then stock options trading would one day wipe out your entire account in one fell sweep.
So, how do we avoid such a predicament?
Simply by applying the golden rule of stock options trading! That is:
Use Only Money You Could Afford To Lose!
Yes, if you could afford to lose only 10% of your account at any one time, you should use no more than 10% of your account on any single stock options trade! This rule is especially important if you are trading out of the money options which have an incredibly high chance of expiring worthless.
For example, if you have a $10000 account and you do not wish to lose more than $1000 at a time, $1000 should be the amount you use on any single stock options trade. Simple as that! The obvious drawback of this rule is that you will not make as much money as you would have if you had simply punted all your money on a single trade, however, just like you would never bet all your money on a single gamble, you should also never put all your money into a single options trade no matter how confident you are! In fact, this applies to any form of trading as well. It takes a little discipline to stick to this rule especially if you are “on a roll” and tempted to go for a “show hand”. Let me assure you that there never is a problem with making lesser money but there always is a problem losing more money!
In fact, when you are using only money that you could afford to lose in stock options trading, you sleep better knowing that you cannot lose more money than you have decided to lose! Your holding power becomes greatly enhanced and you could ride out temporary downturns better than those stock options traders who punted all their money in one trade. This consequently translates to a higher chance of a win as most stocks eventually come back profitably after temporary pullbacks!
So, stick to the “Use Only Money You Could Afford To Lose” golden rule of options trading and you will be safe in your journey to financial success with stock options trading!

Option Trading Explained – In Layman Terms

admin — Tue, 01 Dec 2009 01:10:06 +0000

Robert Kiyosaki says that Option Trading is the investment of the rich.
Indeed, option trading is the most versatile form of investment in the world today. Its versatility has been the topic of many speakers all over the world. Terms such as “Covered Calls” and “Credit Spreads” have become well known amongst traders new and veteran alike.
Option Trading Explained – Simply put, it is the trading of option contracts on a particular stock.
Options Explained – A contract that allows you to sell or buy a stock at a predetermined price within a set time frame.
There is enough material written explaining the technical make up of an option and I shall not dwell into it further in this writing. The purpose of this writing is to explain to you what the effects of option trading is. … let’s go into Option Trading Explained!
Option Trading Explained – What Can Stock Options Do?
Let us first examine the effects of this thing called stock options. Knowing all the effects of stock options allows us to better understand why it is such a celebrated investment tool and also why so many people go bust doing it. Let’s start from the Positive Effects of stock options.
Stock Options are:
Leverage. It allows you to control more shares (100 shares per option) with the same amount of money thereby exponentially increase your returns per dollar.
Discount. Just as you control more shares with just one option, you will then be able to control the same amount of shares with lesser money than before.
Protection. It allows you to protect the stock you hold by owning the right to sell them at a predetermined price no matter what happens.
Regardless of market direction. It allows you to profit from both upward and/or downward moves in the stock.
Creative. It allows you to put different types of options together to form all sorts of investment positions. It can even make money no matter which way the market goes.
And the Negative Effects are:
No value beyond expiration. You can potentially lose all your money along with the expiration of the option.
Negative Leverage. Just like it can amplify your gains, options will also amplify your loses.
Time Decay Effect. Options reduce in value over time and sometimes can completely obliterate any gains from movement in the underlying stock.
Looking at the above effects, it is clear that Option Trading indeed is an extremely versatile investment tool that allows its investor to profit from any market direction, protect his/her stock positions, reduce capital commitment and lots more, based on the way it is utilized.
Conversely, once such power of leverage is being abused, the investor could then lose everything he/she have put in by expiration or lose more from the same stock move than he/she is comfortable with. Also, by holding on to Options, time decay sometimes can obliterate your profits if the movement in the underlying stock is not big enough.
Therefore, investing in options requires careful planning on the part of the investor. You must know for what effect are you using options for and how much you are putting at risk. In essence, using options for Leverage confers the highest risk and the highest rewards and demands that you use only proven strategies with a proven track record.
Using options creatively even allows us to structure investment positions to reap a fixed monthly return that beats the market regardless of which way the market goes! Just like in the Ride the Flow System offered at http://www.mastersoequity.com/MOE_ridetheflow.htm . Where your capital can be fully protected no even if the market enters a severe drop. Sounds amazing?
Option Trading Explained – Conclusion
I hope this “Option Trading Explained” has given you a good overview of the effects of options.
For a full and complete education in option trading, please visit http://www.mastersoequity.com/OptionUni.htm