The way to succeed in stock market trading is to be able to choose winning stocks and to know how to trade them in order to gain a profit, preferably the maximum profit possible, and to do so with an acceptable level of risk that is commensurate with the potential rewards and the preservation of working capital. But that cannot be achieved without a knowledge of the stock market basics regarding how the market works, such as we describe on this website.

Learning how to trade in the stock market takes a serious commitment to study and research and will take a lot of effort and diligence in addition to reading the content of websites such as this one, and that is what I want to address now. This website will point you in the right direction and bring to your attention many important facts, situations, and aspects of stock market trading.

The importance of this stock market basics website is that it provides a range of information that introduces the reader to some necessary trading related topics that they might otherwise not be aware of — and I believe that is information of genuine value, it helps to know what must be learned, from suggestions about books to read to specific rules to follow when making certain types of trades. For an outline of such topics, check out this link to Stock Market 101.

With my comments here today, I will suggest some simple steps that I believe will help the beginning trader understand some of the facets of the market and what might be done to avoid some of the costly mistakes that almost everyone makes in their early days, at least those who jump into trading without knowing some of the stock market basics that subsequent experience teaches to those who have the ability to learn.

It takes knowledge, judgment, and experience.

• The first requirement is to accumulate a sufficient body of appropriate knowledge. That includes the stock market basics and how to keep informed of events that impact a particular stock issue or the market in general.
• A second requirement is the development of the good judgment that leads to making profitable decisions. It is debatable whether this can be learned, but a good substitute is to establish a set of rules that can guide decision-making — and those rules CAN be learned.
• Experience is obviously acquired over time and only after a sufficient number of market actions have been taken. The outcomes from actions taken in the past should provide some insight about what typically can happen as a result of a specific action taken in a particular circumstance.

Most traders have gained the essential knowledge through experience and trial and error at considerable expense and time.

How to obtain stock market knowledge
I do believe that the way to obtain the essential knowledge of stock market trading, even beyond just the stock market basics, is through study first followed by implementation of what is learned. They can be pursued one after the other or simultaneously — and they may cost money in some cases, although there are many internet sources that provide a substantial amount of free information.

1. Subscribe to a course of stock trading education that provides the essential grounding in how to trade stocks. I will research some of these and report back on what they have to offer, what topics are covered, and approximately what they cost. For their clients, many stockbrokers provide free training courses or training on various aspects of trading and trading strategies.
2. Start by trading  “on paper” using a free virtual trading account either through a stockbroker or through an independent internet service. Newly learned trading routines can be initiated without using real money and all the support services for quotes and charting are usually available as are all the follow up recording of the simulated transactions and their results. The virtual trading account enables a familiarization with what is required to actually make a stock transaction and how to track it through the stockbroker’s services.
3. Subscribe to a reliable and competent service that supplies both a reliable series of stock selections that can be traded and instruction on ways to trade them. The service should also provide explanations of why the selected stocks are trading candidates and any logical reasons leading to their selection. The performance record of the service must be available and verifiable and there should preferably be a trial subscription period.
   
   It is essential to the learning process that the reasons for any trade that is recommended by the service is completely understood and that the trading recommendations are not just followed blindly without making a personal assessment and interpretation of the reasons given.

I have made reference elsewhere on this website to some of the above matters in other articles that might be worth checking out, you can find a couple here: Stock Market Courses and Learning and also Stock Market Training.

Before we address the main topic of this article on trading options, a general comment as a reminder of the advantages and the risks of buying options compared to buying the underlying stock.

The advantages that trading options have as an alternative to trading stocks is twofold, the first is that it is much less costly to enter an options position than it is to buy stock issues and secondly, the maximum downside risk is limited to the cost of the option, which as stated, is relatively small. If the trader decides at the beginning that such a loss is too high to suffer, then the trade should not be made.

The higher the price of the underlying stock, the higher will be the option costs, The lower priced stocks provide abundant opportunities to buy options at modest prices. And the small trader, small in the sense of being less capitalized, can in any case buy fewer contracts, whether that be 10, 5, or even just 1 contract. With the right underlying stock at any price and a winning trade, the returns can be very worthwhile. The important thing is to not compromise the rules of minimizing the risk by buying the cheap options just because of their price, those are the most frequent losers by far. Check this link for guidance on the Four Rules for Trading Options.

The risks in option contracts, while limited to the cost of the position, relates mainly to the fact that they expire within a set time and even when attached to a stock that is performing to some degree according to expectations, the expiry date may come too soon for the option holder to benefit from any eventual movement that the stock ultimately takes, whether to a higher price in the case of long calls or to a lower price in the case of put options.

Trading Options, Extending the Basic Strategy
Following up a recent post on this site about trading options, find it here, there is an “add-on” strategy that many traders don’t know about, or so I have been told. That may not be true but even if it is, you should know about it and maybe practice it by paper trading if the right stock situation presents itself.

The strategy is an extension of the basic options trade, whether calls or puts, but for the purposes of illustration, let us describe the action for a long call, the put option strategy is the same but reversed for the extension part.

The usual routine
The normal scenario in a winning call option play, using the approach that I prefer, is to allow the underlying stock to rise to its highest price. Depending on that price, there are two possibilities for exiting the position:

1. the option would be sold if the stock falls back sufficiently to trigger a sell signal based on a trailing stop loss entry, [see note below] or
2. when the option price reaches a delta value close to parity, say in the 90’s, the option is sold or rolled up to a higher strike priced option.

Note:
For an explanation of Stop loss, essential to know about, visit Stop Loss and Exit
For an explanation of delta and the “Greeks”, and for an explanation of Rolling up, both essential to know about, visit this link.

The “add-on” strategy
In this method, the option is not sold, as described in the above scenario, but is held and at the same time a new trade is opened in a separate account in which the underlying stock is sold short with the same number of shares as are controlled by the options, for each option contract that is 100 shares. To sell short, the account has to be a margin account.

Without risk
There is no risk in this strategy because the option to buy shares at a lower price offsets the risk of being obligated to buy shares to cover the shares sold short. The option contract controls the same number of shares as the number of shares sold short.

The objective is to capture the fall in the price of the underlying stock from its recent high price to a sufficiently lower price that it will provide a greater gain than there would have been with the normal selling of the option near to its highest price. As the underlying stock price falls, the option still being held would also fall in price but the short sale of the stock would be providing gains.

This strategy cannot be profitable for every options play, it does depend on a sufficient decline in the price of the underlying stock. But any substantial fall back in price from a given higher price would have been because of some negative factor involving the stock that would, at the same time, signal the likelihood of a coming fall in price to knowledgeable traders. The market reacts very quickly to bad news and often overreacts, providing additional opportunities for the short seller, and where, sometimes, professional traders exacerbate the decline because of their extensive selling activity, that is how the professionals make their money, we smaller retail traders just “ride their coat-tails” so to speak.

This strategy might be easier to grasp with an example and an illustration. Such an example, together with a stock chart, can be found here at my companion site, How to Trade Stocks. On that same site there is also a  description of the strategy described her that might be worth checking out. As suggested, this is a strategy that can be tested best through some paper trading.

Requirements
The success of this strategy requires owning a long call on an underlying stock that rises substantially in price from its strike price but, for one reason or another, then begins to move lower in price. The steps then following are

1. Do not close out the winning option trade but continue to hold the long call
2. Sell 100 shares short of the underlying stock, or the number of shares controlled by the call options being held. There is no risk due to having the long option call still in place, if the stock were to reverse in price and go back up, the short sell would become a losing position but the stock option would rise in price, canceling out any loss on the short position.
3. When the extent of the moves of the stock can be seen to be at an end, it is time to sell the option and cover the short position. If the stock has moved down substantially and continues to do so to a price lower than the strike price of the call, the call will be probably be worthless but the short sell has become increasingly profitable. It is important to monitor the stock carefully to not be caught by any subsequent reversal in the downward trend of the stock, a trailing stop loss should help minimize the risks if and when that happens, as it inevitably will.

Return to List of Topics.

Only the delta is important to us
In Options Trading, the 5 Greeks are: Gamma, Delta, Theta, Rho, and Vega. They are described below but at our level of trading it is only the Delta that we need to know about. The rest can best be left for the professionals.

The trader does not really need to know anything about the academic theory of options pricing or the background leading to the development of a mathematical model that calculates price changes and their relationship to a number of trading variables, a model known as the Black-Scholes model. Suffice it to say that you know it exists. Just for the record, the Greeks are listed here. Don’t bother to remember them, you can look them up if necessary but I don’t know why there would be any need to, at least in the early days of trading options.

Factors in the Black-Scholes equation are referred to individually by letters of the Greek alphabet, namely:

Gamma – is a measure of delta’s sensitivity to changes in the price of the underlying asset.
Delta - is a measure of an option’s sensitivity to changes in the price of the underlying asset.
Theta – is a measure of an option’s sensitivity to time decay.
Rho – is a measure of an option’s sensitivity to changes in the risk free interest rate.

And a fifth factor is named Vega, not really a letter of the Greek alphabet but most people assume that it is — but it really doesn’t matter anyway.

Vega – is a measure of an option’s sensitivity to changes in the volatility of the underlying asset.

Delta is the numerical quantity, a decimal number between 0 and 1, assigned to the value of an option in relation to the price of its underlying stock.

As a stock rises or falls in price, its delta value of the option will change accordingly. For practical purposes, when expressed in a chart of available options for a specific stock, the delta indicates how much the option can continue to gain in price for every $1 that the underlying stock gains in price from that point.

My own “interpretation”:

For an easier way for me to understand it is to ignore the decimal point and when I see a delta value such as .63, I read that as 63 (sixty-three). That 63 in the case of an option that has a delta value .63 tells me that the option will increase in value by 63 cents when the price of the underlying stock increases by $1.

Example: If an option’s delta is .63 when the underlying stock is at a specific price, the value of the option will increase by 63 cents if the stock rises in price by $1. If the delta is .55, the option will increase by 55 cents when the underlying stock goes up by $1.

And so on, the delta tells you how much the option will increase with every $1 increase in the underlying stock and from that point each change in stock price will have a different delta value than that of the stock’s previous price, higher when the stock goes up, lower when the stock goes down.

To state it a little differently, as the price of the underlying stock continues to increase by each $1 amount, the delta value will also change and increase gradually in unison with the $1 price increases in the stock, from. 63 to .64, .65, .66, on up to a possible 1.0 at which time it reaches its maximum, meaning at that point for however many $1 increases occur in the value of the stock, the increase in the option delta stays at 1.

The delta is not a fixed percentage of the stock’s price and the values are derived from a formula that takes into account several factors, including the price of the stock and the time left until expiry of the option. As the call option gets closer to its expiry date, its delta approaches closer to 1.

It is difficult to explain or to comprehend from an explanation, it is easier to understand how it is used and I will just say that experience taught me to:

1. Select an option with a delta value in the low 60’s if one is available.

2. As the price of a stock rises, the delta of a call option will also rise towards the maximum of 100, if it reaches that level or even to the 90’s it is time to sell the option or roll up to a higher priced option. The term ” roll up” is explained below.

Those are my own methods that I found useful and to be guidelines of value, I don’t recall seeing them written anywhere, it is possible that other traders use the delta values differently.

Rolling Up
To Roll up means to exit the current position while simultaneously taking a new position in an option with a higher strike price in the same underlying stock. That would be done if it is believed that the stock will continue to go up in price. And the position would be closed when the option has a delta in the high nineties because the range of possible profit is less than it would be with a lower delta – such as in the 60’s.

There may be other factors to take into account when making such decisions, including the market action in general, the pattern of the stock’s action, volatility of both, or other related aspects that differ and affect various trades.

Management of risk in trading options and minimizing the risks attached to all trading activities is paramount and should be a guiding principle.

For the small speculator venturing into stock market trading, a possible attractive avenue of promising financial returns is in trading options. But before mentioning the advantages, let us address the most frequently cited negative aspects of trading options.

A poor success rate when using flawed strategies
Most option traders lose money, even those, it seems, with experience in trading in stocks and who are knowledgeable professionals working in the stock market. The figure often quoted is that 90 percent lose money with options, that’s a terrible record. But professionals know it and admit to the fact.

A major reason that losses occur is that trader’s are attracted to the cheap options that are out of the money with a near term expiry. Cheap to buy, yes, but far too risky and only occasionally likely to provide a winning trade. Follow the link at the end of this trade to Four Rules for Trading Options.

Many investors believe that trading options is akin to gambling in Las Vegas – and at the high-risk tables. I’m not sure if they have high-risk tables, I’ve never been to Las Vegas and don’t gamble, unless it really is gambling to trade options.

Not everyone fails
On the flip side, many full-time traders do very well with options and trade them on a frequent basis. One very experience trader I know of and whom I do believe is successful, claims he has only traded in options for many years, never in stocks.

My favorite pundit on investing and trading for the beginner, William J. O’Neil, founder of the Investor’s Business Daily and author of many best selling books on investment, has written on the matter with a cautionary comment. His opinion is that once a person has shown they know how to make money in common stocks and understands the market, only then “ the limited use of options might be intelligently considered.”

Options can provide a big bang for a buck if used properly. Options are also widely used for hedging by sophisticated professionals with a high degree of success and profit, in fact their original use, dating back hundreds of years, was primarily to provide a hedge, a form of insurance in many transactions involving a variety of equities. But that form of use is not what we are considering here.

Start with simple call and put options
But the beginner, if deciding to trade in options, could start with the simplest and easiest form of option play, to buy either call options or put options.

The usual definitions for an American style of stock options are:

Call
A call is a contract that conveys the right, although not the obligation, to buy a specified stock at a specified price within a specified time, after which the option no longer exists.

Put
A put is a contract that conveys the right, although not the obligation, to sell a specified stock at a specified price within a specified time, after which the option no longer exists.

Contract
A contract controls 100 shares of the underlying stock and the option price is indicated per one share, the actual cost of the contract being 100 times the individual one share option price.

The above reference to American style is made because there are other less common options styles such as European style options that have different rules.

To be successful in trading options the trader must be able to pick stocks that can reasonably be expected to perform as forecast within the given time before expiration, either rising in price or falling in price, depending on whether a call or put.

Choose the stock, set the option strike price and the term
When buying one or more option contracts on a specified stock, two other conditions must be specified, the “strike price”, that is the price at which the option can be executed and the “term” that specifies the date at which the option expires.

Strike Price
The strike price can be a price above the current market price of the stock, below that price, or the same price. In stock market terminology those are referred to as “out of the money, in the money, or at the money” respectively.

For a call, the more a strike price is priced In the Money, meaning priced at a lower strike price than the current market price, the more expensive the option will be compared with a strike price that is At the Money or Out of the Money.

Term, Expiration Date
The term specified indicates when the option expires. There are usually several dates of expiry available for various months in the future that conform to pre-set calendar dates and their option prices will vary accordingly.

The closer the expiration date is set to the current trading date the lower the price of the option should be and the higher would be the risk because of the shorter time to realize the required change in value of the underlying stock.

Leverage is the great advantage
It is the leverage provided in trading options that is the great benefit. A comparatively small amount of money can allow participation in the trading activity of much higher priced stocks. The smaller financial stake allows the smaller retail investor to trade options in cases where the higher investment required for high priced stocks may tie up too much working capital for comfort.

There is higher risk involved in trading options but the potential returns on a successful option trade should be many times the amount in percentage terms that would be gained in a straight stock purchase.

Limited Loss
It is an odd consolation but the most that can be lost in an options purchase is the total amount paid for the options, with some exceptions that the beginner should not be involved with. So that amount at risk with a call or put option is fixed. And the option can be sold before the expiration date to reduce a potential loss if there is sufficient time left until expiration and if there is any positive intrinsic value, the difference between the strike price and the underlying stock price. The option is usually worth at about what the option holder would receive if the option were executed.

In Conclusion
To repeat, success depends on the ability to pick stocks that perform to expectations within the specified term. It sounds simple and it doesn’t always happen but when it does, it is very rewarding. Definitely worth reading up on to learn the strategies to adopt that give the best chance of success and at the same time minimize the risks involved.

For some more specific guidelines on setting strike price and term, check out this link:
Four Rules for Stock Options.

Regarded by many as a high-risk activity comparable to playing roulette or black jack at a gambling casino, trading options is avoided by many investors and speculators who trade regularly in stocks. Those same stock buyers and sellers who invest in the stocks of their choices to make money, are buying or selling the very same stocks that are also probably available for trading options.

Since that is the case, why not at least consider setting aside a small percentage of speculative working capital to buy an option on those chosen stocks? Trading options successfully provides a bigger bang for the trading buck and by using conservative simple strategies when first beginning to trade options, the element of risk attached to options can be minimized. After gaining confidence with early successes, a trader can then move on to the next level, using more complex strategies that may even further lower the risk. For experienced and professional traders, trading options is an everyday procedure.

The simple and basic approach to trading options suggested here is to start by buying calls or puts on stocks that can be identified as being ready to move either up or down in price. For whatever reason their move is triggered, stocks do break out of their trading ranges to climb, or descend, to new levels. Whether trading stocks or options, the speculator waits to take advantage of such moves when they occur.

Advantage and disadvantage
The advantage that options provide is that less working capital is required to take a position to capture profits attached to the stock’s move in price. The downside is that the option is time sensitive and if the anticipated price change does not occur, or does not occur within the time set by the option contract, then the option loses value and may become worthless.

Stock option by definition
A stock option is sometimes called a derivative because its existence and value is derived from another asset, in this case the underlying shares in a company. Options can be attached to many other forms of asset, not limited to financial instruments. Options are often related to purchases of land, buildings, or any other form of ownership or property. Option contracts traded on the American Option Exchanges are known as American style options, there are other styles traded elsewhere that have different rules attached to them, mainly the European style options that cannot be exercised until the specified expiration date.

American style options do not have to be held until the expiration date to be exercised. Most stock options are not exercised but are bought and sold for speculative purposes, and many expire worthless.

There are two forms of option, related to future events of either buying or selling, they are called Calls or Puts, calls in connection with buying long, and puts for selling short.

A call stock option is a contract between a buyer and a seller that gives the buyer the right to purchase 100 shares of a specified company at a specified price within a specified period of time.

The put stock option only differs from the call option in its reference to selling instead of the right to buy, but for the record, let us define that anyway:

A put stock option is a contract between a buyer and a seller that gives the buyer the right to sell 100 shares of a specified company at a specified price within a specified period of time.

So there are three components:

• the company stock, referred to as the underlying asset.
• the specified price, also referred to as the strike price, or the exercise price, or the settlement price.
• the date when the option expires, the expiration date or expiry date.

The key factors to success
The options markets provide a range of strike prices and expiration dates for options. The key to successful option trades lies in the right choice of those components. The need is to identify :

• a stock that moves up or down as anticipated
• an option with an expiry date far enough away to allow the time needed to capture any gain from the stock’s future move. That may take a while to achieve, an expiry date too close to when the option is purchased may not allow enough time and the option could then expire worthless or worth little.
• a strike price with enough dollar differential between the its own price and the price achieved by the stock before the option expires.

Leverage
The primary benefit of owning options over stocks is the lower cost of investing. Options cost a fraction of the cost of stocks, often about a tenth of the price, but they still benefit from the same amount of price movement that takes place in the more expensive stocks.

Limited Loss
The maximum amount of loss that can occur is the amount paid to acquire the options. A negative factor, but it allows the person trading options to set the amount to place at risk within a range they can tolerate.

Higher Risk
There is a higher risk attached because the element of time diminishes part of the value of the option as each day passes and the risk for potential loss increases when the underlying stock does not move as expected and if an insufficient price move occurs, the option can end up worthless.

For more on stock trading and suggestions for simple options, check out Four Rules for a Basic Stock Option Trade and also Trading Options as an Alternative to Trading Stocks. Read the rest of this entry

The stock chart is a graph of price and time that can show stock market activity that occurred during the past and up until the present. As such, the chart becomes a useful aid in the prediction of future stock movement that might reasonably be expected to repeat the patterns exhibited in stock activity of the past. That is the value of stock charts, their ability to reveal emerging patterns of stock price fluctuations that can be recognized and compared with what typically happens when they occur, based on the frequent results obtained in similar situations previously.

This is a stock chart, please click on the chart to see it a little sharper.

Sample Chart - ISLN

The stock chart provides a tool of prediction, not always reliable and sometimes opinions differ on their interpretation, but nevertheless, charts can convey an abundance of accurate information of past activity in a relatively simple graphic form. Provided in any other way, such information would be more difficult to comprehend and it would be more difficult to draw conclusions from meaningful relationships of various data of importance that the chart can readily show.

The relationships of various factors impacting the price movement of stocks is well understood and the stock chart is able to more easily summarize and graphically show those factors and relationships that would otherwise need to be derived from lists of numerical data. The stock trader and investor needs to know what is happening and the charts provide that information with the minimum of effort required from the reader to interpret.

For that reason, the stock charts is a favorite tool in technical analysis with which the chart reader can deduce and forecast the future path that a particular stock will follow and thereby help guide the decisions of the trader.

A difference between trading and investing
In the context of our explanation here, there is a difference between trading, also called speculation, and investing. In broad terms, the investor in stocks usually has a longer term view, will wish to own stocks for a long time and looks for the stocks of companies that have high probabilities of profitable expansion and continued growth, increasing in value and paying dividends. The great investor Warren Buffet has often said that his favorite holding period for a stock is “forever”, a quote that has been used by other famous and successful investors. The investor is unlikely to rely on technical analysis and stock charts as a guide to choosing stocks to buy. The method of research, data gathering and interpretation used by the investor is known as Fundamental Analysis.

In contrast, the speculator is interested in the short term, the stock itself and its possible price changes being the vehicle of speculation rather than its long-term prospects. The speculator focuses on price movements that occur anywhere from minutes to hours in the case of day trading, to days, weeks and a few months in other styles of trading.

The speculator looks for stocks that will move quickly soon after their position in them has been acquired, in fact it is probably better that the stock price is already on the move when a position in a stock is being taken. And the speculator is also willing to be a seller, called going short, when the indications are that a stock is moving down in price with no prospects of support to prevent its continuation on the downward trend. In times of trouble, as have been seen during recent economic problems, there are many opportunities for the speculator to take advantage of distressed company performance.

The trader’s objective is to identify those stocks that will move in price during a relatively short span of time, stock that can be bought long or sold short. The potential profit is realized when the trade is terminated and subsequently sold in the case of long positions and bought in the case of short positions.

The stock chart for monitoring trades
The stock chart is a valuable aid in tracking the acquired stock position’s progress and together with appropriate risk management, can enable the trader to capture most of the potential profit from the changing stock price. When the chart provides a recognizable signal, the trader can exit the position and the funds obtained from the transaction can again be used for future trades.