Many stock market traders believe that the purchase of options can be a great alternative to buying stocks because options cost a fraction of the cost of their underlying stock but share the gains that the underlying stock can achieve, although conversely, they do also encounter significant losses when the under lying stock loses in price.

Advantages and disadvantages

1. Money at Risk
While the purpose of trading is to make a profit, for a variety of reasons that does not happen with all trades so it is an advantage to know the amount of money that can potentially be lost when buying stocks or buying options.

All stock market trading involves risk but the amounts of money that can potentially be lost in a failed trade can differ significantly when comparing buying shares with buying options.

For instance, when buying shares in a company with the expectation of those shares gaining in value and subsequently some unforeseen circumstance occurs which prevents them gaining in value and actually causes them to lose their value, much of the original investment can be lost unless prompt action is taken to sell the shares. Many inexperienced traders become indecisive and uncertain when to sell, with the result that they lose much more of their trading stake than necessary because of this.

However, in the first place, options cost significantly less than their underlying shares and secondly, the maximum amount of money at risk is limited to the premium, the total cost of purchasing the option when the purchase is made. And since that amount is known at the beginning, it is assumed that its loss can be tolerated by the trader in the case of a losing trade.

2. Potential returns on a winning trade
In addition to paying much less for a stock option, in the case of a winning position, a major advantage in buying options compared with buying stocks is the much greater percentage return achieved by options. Examples of this have been provided elsewhere on this Stock Market Basics website, for example, here on this recent post where it was shown that a certain MPEL option had gained 120% versus the 23.2 percent gained by the underlying stock.

To summarize, options offer the possibility of very good gains with a known and limited risk if they fail to perform.

Disadvantages

1. Losses can be rapid and proportionately greater
While options can make good gains quickly when its underlying stock rises in price, it is quite the opposite when the stock falls in price. If that happens, the percentage of loss in the option is several times greater than the percentage of loss in the under lying stock. The trader has to have the mental ability and fortitude to tolerate a big loss, sometimes a temporary loss but sometimes a total loss — but as mentioned above, any loss is limited to the amount of the purchase premium [except in the case of naked puts, which on this website we do not even think of trading]. My personal approach is to establish the amount I wish to risk and from that initiate a trading position accordingly. If the option price rises as expected I can always add additional contracts and increase my stake from a position of greater strength.

2. Options must perform within a limited time
When a position is initiated, options have a specific length of time in which to achieve their desired results — which are based on the performance of their underlying stock — and beyond that pre-established timespan they expire worthless.

3. Time value of an option decays at an accelerating rate as it nears expiration date
Part of the value of an option is the amount of time remaining until expiration and the a closer the expiration date becomes, the faster the rate of loss until it’s decaying value reaches zero near its ultimate expiration date. So just as it can provide rapid gains it can also result in rapid losses. The guidelines established on this stock market basics site recommend both preference for options of 4 to 6 months away until expiration and the sale of those options regardless of their amount of gain, no later than one month before exploration. This is done in order to recapture at least a small part of the time value that might be left in the option.

Part 2: Stock Options Basics

The standard and basic definition of an option is given in the previous article: Part 1: Stock Options Basics.

An example is given at the end of the following article that illustrates how much more profitable an options trade can be in a winning situation, in terms of percentages, in comparison with owning only the underlying stock.
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More about options
There are dozens of ways to trade stock options and many strategies used, especially by professional traders for purposes other than that of the small trader who merely wishes to make a profit by trading with relatively small capital at risk. This Stock Market Basics Guide caters to the interests of that small beginning trader who wishes to know about the stock market from the beginner’s standpoint.

Caution
Options are not usually considered to be suitable for the absolute beginner but the profit potential is so good that it should become part of a trader’s arsenal as soon as possible on the journey to learn the stock market basics. Paper trade a few examples to become familiar with the process and to verify their profit potential.

Call and Put options
The simple approach to options trading is to buy either call or put options. A call option, or options, would be purchased when the trader believes the stock will move up in price. A put option, or options, would be purchased if it is believed the stock will fall in price.

As has been discussed in several other posts on this site, together with real-time examples, even this simple and basic form of stock option trading produces very good returns when a correct forecast of the underlying stock movement is made — and is usually accomplished in a relatively short period of time. For the option trading approach suggested on this stock market basics site, that would be a period of no more than three or four months since our recommendation is to buy options that expire about four months from the time of purchase and exit them about one month prior to expiration. I know of some successful traders who use only this simplest of option trading methods. Although there is an important alternative to the basic call and put approach, and that is when much longer term options called “LEAPS” are purchased. LEAPS refers to a Long-term Equity Anticipation Security that we have mentioned elsewhere on this website in the post: LEAPS for the Small Trader.

Because there is no obligation to exercise the option, the maximum risk involved, in other words, the maximum amount that can be lost on the basic call or put option play, is the total cost of the option purchase. However, since we recommend exiting an option position about four weeks prior to the fixed expiry date there would normally be some time-value left in the option or options when they are sold at that time to close out the position. This an important aspect because it allows the trader to set the amount of working capital to risk and that amount should be an amount that the trader can afford to lose if the option should become a losing proposition.
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An example of an actual current winning stock option trade compared to a stock only purchase
The following is an example of a trade mentioned on a previous article dated May 31, 2011, on this Stock Market Basics website, that can be found at “What would you do?”.

Towards the end of that article, dealing with the stock with symbols STX and MPEL, the following statement can be seen:
The decision: If nothing changes significantly, the decision is to sell STX and with the proceeds add to the MPEL position (meaning buy MPEL, to add to an MPEL position which was already held).

The MPEL trade: The outcome of that trade and as it stands today is as follows:
May 31, 2011 at 11:19 am with the shares of MPEL trading at $11.08, a purchase was made of MPEL October 11 options  (meaning a strike price of 11 and the month of October expiration date) at $1.50 (meaning that each contract cost 100 x 1.50 = $150.00 ignoring brokerage fees).

At today’s close, July 11, 2011 the MPEL shares trade at $13.65 (after losing 33 cents on the day)
The October 11 IMPEL options closed at 3.30 bid x 3.50 asked

In summary:
1. If closed out today, the option trade would have yielded
3.30 – 1.50 = + 1.80 = 120 % gain.

2. If the shares had been purchased instead of the options, the arithmetic shows that the gain would have been 13.65 – 11.08 = + 2.57 = 23.2 % gain.

I’m sure you can see the difference!

Editor’s Note:
Just to keep things in perspective, I should mention that not all option trades turn out to be winners as this one currently shows to be, and it should also be kept in mind that there is no profit on a winning position until that position is sold.

Although often decried as highly speculative and risky  — an incorrect assessment in my opinion, stock options provide the trader with an important alternative to buying stocks that has the advantage of potentially higher returns on a dollar for dollar basis and a known-in-advance amount of maximum dollars at risk involved in any transaction.

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Part 1: Stock Options Basics

Options and leverage
A major advantage of trading options is their much lower cost compared with the price of the stock to which they apply. Because of this, the options buyer can control a number of shares whose market price might otherwise be too high to buy, thus the term leverage is appropriate to describe this attribute.

Definition and some basic option terms
A stock option is a contract that conveys the right to buy or sell a stock, usually referred to as the “underlying stock”, at a specified price, referred to as the “strike price”, for a specified period of time.

There are two categories of stock options, called Calls and Puts respectively. Each contract, whether a call or a put, represents the right to buy 100 shares of the underlying stock. Options traded on the North American stock exchanges do not have to be exercised and are often allowed to expire worthless without penalty on their pre-established expiration date.

Stock options can be bought or sold and are traded through a stockbroker in the same way as stocks, using the normal bid and asked system to establish their trading price, referred to the “premium”. The premium varies according to the chosen strike price and time remaining until expiration. The expiration dates for stock options listed on the north American exchanges occur on the third Saturday of the month, meaning, for practical trading purposes, the Friday preceding that Saturday, or the Thursday if there is a holiday on the Friday.

Not every month has an available expiration date for each individual stock. The stock’s options are assigned to a pre-set expiration cycle of which there are three, the January cycle, the February cycle and the March cycle.

For much more on options, check out the Chicago Board Options Exchange (CBOE) and especially useful on that site for a quick reference is the Glossary.

LEAPS the exception
It should be noted that there is a somewhat special category of long term options that do not follow that pattern of expiration dates but expire in January of any one of the following three years. LEAPS are important to learn about and will be dealt with separately. An earlier reference on this Stock Market Basics site can be found at When Working Capital is Limited, worth checking out to see what has happened in the interim.

Also, for practical purposes, options are not often exercised but are considered merely as a product to be traded in the same way as other trading. However, there is a major exception, they would frequently be exercised when they are employee options or any similar types of “privileged” options, sometimes available as a bonus or incentive in many companies.

Time value and intrinsic value
Time is an important component of an option and part of the premium relates to the time remaining until the option expires, therefore referred to as the “time value”. The remaining part of the premium is referred to as the “intrinsic value”. As each day passes, the time until expiration date becomes less and consequently the time value gradually diminishes at an accelerated rate the nearer it becomes to the actual expiration date. Time value is generally referred to as being a “decaying asset”.

The Strike Price
As mentioned above, when the option is purchased, the price at which it can be exercised, the strike price, is established and can be any of three possibilities,

1. A future price that is lower than the existing stock price, referred to as “In the money”
2. A future price that is the same as the existing stock price, referred to as “At the money”
3. A future price that is higher than the existing stock price, referred to as “Out of the money”

There are many ways to trade options and they have practical uses in many situations other than merely as a vehicle to trade like stocks, however, at the level of this stock market basics site we will limit our references to a few of the simpler versions that meet our needs as beginners learning the stock options basics.

Forthcoming articles:

More on this topic will be covered in the next few posts to this website, Part 2 will provide an example of a winning options transaction and Part 3 will deal with the option strategy known as “Spread Trading”, another relatively simple alternative to buying stocks.

Profit and loss and the successful trader
To be a truly successful stock market trader, requires an ability to consistently make greater amounts of profits than losses through a series of trades over a length of time. The ratio of wins to losses is not as important as the amounts of profits that can be consistently achieved compared with the total losses that occur. To be successful requires the ability to correctly forecast, a sufficient number of times, the direction in which the price of stocks will move, whether up or down, and to take the appropriate trading position that can derive financial benefit from those anticipated stock price movements.

When you can successfully forecast the future movement of most of the stocks you examine, there are several ways to trade and take advantage of the price movements of those stocks. You might call them trading strategies, ways of trading that entail varying amounts of risk and potential gain to compensate for that risk.

Knowing that not every stock selection will be a winner, sometimes for reasons not directly connected with the individual stocks, a successful trading strategy must have established guidelines on actions to take that can minimize risk and preserve trading capital if and when the inevitable unforeseeable losses occur. Therein lies the art of survival in the trading arena, a very unforgiving and costly environment for the unprepared.

This article is important, it discusses stock options basics information for beginning traders or aspiring traders, information which is often neglected by many because they may have heard a common refrain that “options are risky” — or are “complicated”. Learn about options trading first and then let knowledge and experience guide you on whether that is an accurate description of options and options trading.

For most stocks that trade on the major stock exchanges, there is also an active market in the trading of related options that convey the right to buy or sell those stocks, usually referred to as the underlying stock, at a specified price and within a specified period of time. While that right to buy or sell the stocks exists, it is rarely exercised, options are used for trading the options only, in and of themselves.

Options are traded through a broker in the same way as stocks and other than understanding the basic principles, it is not really essential to know much more.

However, our next few articles on this site will provide a standard definition and some other details on stock options basics and strategies that may be of interest, together with suitable examples of comparative results, and some suggestions of option plays that can be followed, in real-time trading as it unfolds, by visitors to this Stock Market Basics website. We will do that by paper-trading to compare the results of buying shares of a few selected stocks versus buying options for those stocks — we have done that in the past on this website and shown some very profitable paper-trading results.

For the purposes of the stock market trader, an stock option is just another financial vehicle to trade, something connected with a stock to buy or to sell with the intention and expectation of making money on the transaction if the stock performs as expected.

In the most recent post on the Stock market basics guide website, it was pointed out that an alternative to buying stocks would be to buy shares in an Exchange Traded Fund (ETF). In that post, reference was made to ETF’s of the major stock exchanges, the DOW, the NASDAQ, and the S&P. Specifically featured was the Nasdaq ETF know as the Q’s – symbol QQQ for which examples and charts were shown.

The QQQ ETF was chosen because it was the least costly of the 3 index ETF’s. At the end of the previous article it was mentioned that an explanation would be provided on other ways to trade QQQ that could provide a bigger return on dollars invested.

There are two ways that can be accomplished, both of which carry somewhat higher risk. But the returns, if achieved, are sufficiently high to warrant the risk. The key to making gains in trading is to be able to correctly forecast the direction of the price change of the underlying stock issue concerned, in this case the Nasdaq exchange and its ETF, for which we have assumed that the market will continue upward.

The two alternatives to buying stocks or ETFs

Alternative 1: Buy QQQ Calls.
A Call is an option to purchase shares of an underlying stock issue, in this case the QQQ trust fund. They are easily traded in the same way as shares, usually with the same stockbroker. The price of the option is established at the time of trading via the normal bid and ask process and specifies an exact price at which the option can be exercised at a later date, called the Strike Price, within a specified time period. A winning option position normally provides much higher gains in terms of percentages than the gain achieved by the underlying stock. The total dollar amount at risk can be significantly less than the amount required when buying stocks.

Like any trade in the stock market, sometimes the underlying stock and the option may not perform as expected, their values may decline as time passes — the stock loses money which makes it unprofitable to exercise the option – but it is not necessary to exercise the option, many options expire without being exercised and usually expire worthless or valued at less than the cost of a stockbroker’s transaction fee.

Stock options basics are explained in several other articles on this Stock Market Basics website. For instance, see Trading Options for the Beginner.

Alternative 2: Buy shares of the QLD — ProShares Ultra QQQ
The ProShares Ultra QQQ is a “leveraged” alternative ETF fund that has the objective of doubling the daily return, making at least two-times the daily gain of the QQQ fund. More expensive than the QQQ but it’s the ROI (Return on Investment) that is important

Learn more about ProShares here.

To track and compare the future results, starting yesterday July 7, 2011:

The QQQ closed yesterday at $59.19 with a day’s gain per share of 80 cent (1.3%)

The QLD closed yesterday at $95.20 with a day’s gain per share of $2.67 (2.89%)

When the QQQ makes a loss for the day, the QLD will make a greater loss for the day.

Options on the QLD fund can also be bought in the same way as options for the QQQ – another way of leveraging the trade for a possible greater return.

Suggestion: Learn about options as an alternative to buying shares
It is recommended that beginning traders, who are wishing to learn the basics of stock market trading, should spend some time learning how to trade in options as an alternative to buying shares in a company. A paper-trading test exercise to compare the results can be made by buying both shares and options at the same time and tracking the results – but a warning: to lower risks, it is necessary to follow specific guidelines suggested elsewhere on the Stock Market Basics website, see the link given above, and also see: Four Rules for Trading Stock Options.

Charts of QQQ and NDX shown below.

Our previous post indicated in its title that the indexes have signalled that it’s time for buying stocks once more after a period of watching from the sidelines, and that title was based on the chart indications that showed the S&P 500 stock index had, last week, reversed its downward path, moved back up, breaking through resistance levels and had established a new upward trend. Our hope is that trend will continue and we will watch the charts for confirmation of that.

Our post also listed several stock’s that we would wish to buy for our previously mentioned “Stock market basics paper trading portfolio # 3” that we have referred to from time to time these last few weeks while we have waited for the S&P to reverse its recent downtrend and to give us the signal that the time is right for buying stocks again. For traders it is customary that they have a “Watch List”, a list of stocks that have already been compiled, checked, and qualified as potential trading candidates. The pre-qualified stocks on the watch list helps simplify and speed-up the decision-making process for buying stocks when prompt action is necessary.

Exchange Traded Funds as an alternative to buying individual stocks
However, it might be interesting to consider the situation where a person may not be able to identify individual stocks to buy. If that occurs, it might be a good time to take a position in an Exchange Traded Fund (usually abbreviated to ETF), of which there are many. To keep things simple, and for the paper trading purposes that we use as examples for those who are in the learning stage of the stock market basics processes, it is suggested to paper trade at least one of the funds of the major stock indexes, those being the DIA fund for the DOW, the QQQ fund for the NASDAQ, or the SPY fund for the S&P 500. The action of the ETF’s mirrors the action of their exchanges as can be readily seen by comparing their respective charts – for free stock charts go to StockCharts.com. The charts shown below illustrate the similarity of the trading patterns of the Index Fund and its Index.

Brief definition of ETFs
Without going into detail, an Exchange Traded Fund (ETF) is not unlike a mutual fund, in the sense that the funds compile their appropriate group of stocks that represent the nominated topic of the fund. In the case of the ETF’s, that would be a group of stocks chosen from the stocks that trade on their respective stock exchanges, sometimes referred as “stocks that track the index”. ETF shares can be traded at any time of the trading day and have high liquidity, meaning that there are always buyers and sellers available to complete a transaction, subject to the bid or ask being met of course.

The least costly of those 3 ETF’s is the Nasdaq’s Power Shares QQQ Trust, with the symbol QQQ, also unofficially referred to as the Q’s. QQQ closed today, July 5, at $58.26

Check  out this link for an explanation of Nasdaq’s 100 Index

Here are the charts of QQQ and the Nasdaq 100 Index – it can be seen how similar they are.  Click on charts for enlarged view

Chart of QQQ July 5

Chart of NDX July 5

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Watch for Tomorrow:
There will be an explanation of ETF versions that can provide a bigger return, dollar for dollar.
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It was only three trading days ago, on June 28, that I had suggested the SNP 500 index was indicating the end of the downwards trading pattern and is ready to change to an upward trend – something we have all been waiting for to re-enter the market and again start buying stocks after sitting on the sidelines for so long. [That post with charts of the S&P and of the suggested stocks for our paper-trade portfolio can be seen at Time For Buying Stocks?]

Well, the following three trading days proved to be very positive with good gains on each day, allowing the index to break through resistance at several levels until Friday July 1, the S&P 500 closed at 1339.67.

The reversal to the upside cannot be guaranteed to take place. If there is a negative factor it would probably be that the trading volumes are not large enough to show major enthusiasm, but as has been said by others, there is a lot of cash waiting to be invested and a continued upward move might draw that into the markets. And the major earnings announcements will start July 11 and if they are again positive, that should also prompt action – always subject of course to over-riding geopolitical events or major natural disasters.

While I would not be surprised to see some profit taking when they market reopens on Tuesday after the July 4 holiday, that would be quite normal and would allow us to commence buying stocks for our proposed Stock market basics paper-trading Portfolio # 3 – details listed below. For the record, here is the chart of the S&P 500 as of Friday’s close:

Note: Click on the following chart to enlarge for a sharper view:

S&P 500 July 01 Close

Plan for the paper-trading Portfolio # 3
Subject to the opening market action, we can commence buying some of the stocks listed in our post of June 28, which are MPEL, WYNN, LVS, MGM. The charts for all of those are provided in the prior post and the trading for the 3 days since confirms them to be at the beginning of a new upward trend.

Buying shares that follow the NASDAQ Index (NDX)
Since, as traders, we are interpreting the charts of the stock market indexes to be signalling the beginning of a new upward trend, it is appropriate to take a position in one of the ETF’s (Exchange Traded Funds) that track the indexes, the less expensive of those being the fund based on the Nasdaq-100 index, with the ticker symbol QQQ. For the NASDAQ’s description, see NASDAQ Index Shares.

Additional positions can be taken in the QLD, an “ultra” fund of the QQQ that attempts to double the performance achieved by the Nasdaq 100 Index. For the NASDAQ’s description, see: Bet on the Nasdaq, that article is out of date but is informative anyway.

Here is a chart of the Q’s:

Chart of QQQ Index Fund - July 01 close

Editor’s Note:
For the record: This Stock Market Basics website is meant to serve the interests of persons wishing to learn about trading stocks and emphasizes the need to follow some basic guidelines that many of the most successful traders also follow in order to minimize risk and preserve working capital. The examples provided here are real and current but are meant to be used for for illustrative purposes in establishing short-term stock portfolios for paper-trading.
For full disclosure, in reality I do hold an option position in MPEL, as described in the post of May 31, titled: An Exercise: What Would You Do?