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.

 

Related posts:

  1. Stock Options Explained – Part 1
  2. Buy the Stock or Buy the Option? Risks and Rewards in Trading Options
  3. A Case for Buying Options Instead of Buying Stocks
  4. Trading Options for the Beginner
  5. The Stock Chart and a Simulated Trade to Buy Shares and Options of AGCO
  6. Trading the NASDAQ Index with ETFs and Options as an Alternative to Buying Shares
  7. Trading Options with an added “twist” to the basic strategy

Filed under: Stock Market Basics

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