What Are My Options?

Boy oh boy, where does the time go?

I apologize for not being here after the close today, I had a few things to take care of that ran later than I had previously expected. Hopefully this entry will make up for my absence earlier.

The first thing I would like you to understand about trading options is that they are not as risky as a lot of people make them out to be. In fact options were actually designed to help manage risk.

Like most things in the market or investing the general public has it wrong, which is a reoccurring theme you will notice in my entries.

Anyway lets dig into the basics of Options Trading!

An investor can buy a call or put option and define the amount of money they’re willing to risk on the trade or investment up front, without having to put up the money needed to buy shares, and also without worrying about the stock doing a “gap down” past their defined risk level, otherwise known as a “stop“.

Let’s say you think NUAN stock will make a move to 19 very soon and wanted to by at $16.50 a share and set your stop at $15, giving you a $1.50 stop loss on your position of 100 shares, and therefore managing your risk at $150 maximum loss on the trade.

Rather than buying the shares, a trader might choose to buy a 15 dollar “strike price” call option on the stock and define their risk by the cost of the option contract premium.

In this example NUAN closed the day at 16.62, so the bid/ask spread looks like this currently: Bid- 1.60 Ask-1.75

As you can see there is about a .15 spread between the bid and ask. This amount will usually vary during the trading day based on the volatility of the stock.

Take a look at the picture below and locate the 15 strike call option contract to see the bid and ask.

NUANexample

So when a trader buys the 15 dollar call option on NUAN for lets say the asking price of 1.75 in this example, the risk is the price payed in option premium, rather than the difference in price between the trader’s entry and the stop loss price level.

Buying the call rather than the shares also avoids having to tie up capital that could be used elsewhere on another good setup.

The downside is of course that most options contracts expire worthless, and if your trade does not work and you keep an out of the money call option until its expiry date, it will indeed expire 100% worthless. A trader can still manage risk with an option. Such as selling the option once it’s premium price has breached a predetermined level, like less than 50% of purchase price for example. In our example trade, the trader would sell the call when the price of the contract fell below $75.

An option contract can also be “exercised” which is a situation where a trader is holding an in the money option contract and wishes to close the trade by taking the shares of common stock at the strike price of the contract. Investors may do this when they want to capture further gains in a stock because price has exceeded the amount they had projected when purchasing the call option. Once the option is exercised the writer of the option is required to sell the shares to the option purchaser at the strike price of the contract regardless of current market price.

Hopefully I didn’t go too far into the weeds with you in my first entry on the mechanics of options contracts, I honestly tried to be as brief and concise as possible, but there is much more to say on this. However it is getting late and we have a market to trade in the morning. I hope you enjoyed this intro to options trading.  Hopefully you now have some insight into what an option contract is and why an investor or trader may want to use an option strategy.

 

See ya at the bell,

-Merlin

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s