Small Business Resource: How Traders Effectively Use Stock Options

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June 18, 2007

How Traders Effectively Use Stock Options

Options have the ability to generate a substantial income quickly if the price moves in the right direction, and the options are exercised or traded before they expire. Options are appealing to a wide variety of traders because they don't cost very much to buy, even though there are substantial commissions and other charges that are involved in their purchase.

Since options traders only pay a fraction of the cost of actually buying stocks, Treasury note or what ever the underlying investment happens to be, the trader has leveraged the investment. This means that the trader has used a little bit of money with the potential to make a lot of money within a relatively short period of time. If the option that is being traded is profitable, it can be worth a hundred or even a thousand time more than the original investment price.

The premium, or the nonrefundable price of an option has several factors that can affect it, this also includes rumors. Officially the factors that affect the option are based on the type of investment the option is on, the options underlying price, how volatile the price of the option has been over the last year, the current interest rate, and the amount of time that is remaining before the option expires. Premium fluctuations allow traders too get back more or less what they paid for the option when they decide to sell it. The sellers get their money up-front when they write options. This is called a price premium and it is nonrefundable. Collecting the premium is the number one reason for writing the option in the first place.

Aside from the highs that speculating options can provide, stock options do have a practical purpose for traders that are following the markets closely, and specific goals in mind that they are trying to accomplish, like providing insurance for their stock market investments. A method that is used by traders to reduce the risk of buying options is to purchase a married put. this simply means that the trader is buying a stock and a put (sell) option on the same stock at the same time. if the price of the stock options goes down, the put option will go up in value. This allows the loss that is taken on the stock to be offset by selling the put. Another technique that is used is called a strangle, this involves writing a call that has a strike price that is above the current market price and a put with a strike price that is bellow the current market price. This technique allows the trader to collect their premium and neutralize their position at the same time.

Posted by David at June 18, 2007 5:17 AM