Many new traders will use stock options. The idea is simple leverage. A small amount of money can control a great amount of the underlying product. Options can be helpful, but If you as a trader are going to use them, you must understand option basics. You must recognize the possibilities for loss of most, or all of the up front price paid. That loss can happen quickly.
In this article, I want to take a few time to look at the important aspects of options and help traders understand their potential risks and benefits.
An option is only a contract between two parties. It gives the holder the right (or option) to purchase or sell the underlying product at an agreed upon price and date in the future. Unlike a futures contract which requires the holder to purchase or sell, the options holder has a right, but not an obligation. The holder may elect to invoke (or exercise) that option when the date comes due, or if that wouldn’t be advantageous, he’ll simply let the option expire, thus losing his initial investment.
Here’s some more random trading buy options before earnings thoughts…..
Stock Options can be used as insurance as in the case when a producer wishes to be sure he can guarantee at least a minimum profit at a future date, or when an investor wishes to protect an investment against the possibility of severe loss. Options can also be utilized for speculative purposes, such as when a trader may anticipate a breakout.
Stock option trading provides experienced and advanced investors with much more opportunities to potentially make and fulfill rewarding returns. Thus, stock options may also involve risks and some losses; therefore, a rigid research and a sound and thorough understanding of what options really is and how’s that work will help you minimize risk and maximize your profits as an option trader and as a beginning investor.
Trading buy options before earnings
In 1973 Fischer Black and Myron Scholes introduced a landmark option pricing model that persists as the gold standard even today, though it has flaws and one of its founders, Scholes, tarnished his legacy with his participation in the Long Term Capital Management fiasco. The math involved is deemed to be some of the most difficult in all of finance, and though most traders are aware of the inputs and the terminology of the Black Scholes, far fewer truly understand and use it. It is important to fully understand the factors that affect price though. The five contributions to the model are: price of underlying, expiration date, interest rate, volatility, and strike price.
The price of an option is set by the above factors. One of the least well understood by new traders, is the volatility premium.
The important thing to remember is that volatility accounts for much of the cost of the option, and increases in volatility increase that price. This increase can be substantial. It is especially important that options traders have a real grasp of implied volatility, when to expect it to increase, and how it might affect options trades. It is likewise important to see how a trader might use options and still protect against changes in this component of option pricing.
Markets move because of changes in the views of market participants. This occurs for an infinite variety of reasons. However, news is undoubtedly one of the most common and most predictable. When news is expected (GDP, earnings, bond sale, jobs report, etc.) there’s a logical expectation that affected markets may move. This move may be substantial. This leads to an increase in the cost of options premiums, as the date for the news release nears. The actual volatility of the underlying (historical volatility) may not change very much. However, the price of the option does. This price change is attributed to volatility and is called IMPLIED VOLATILITY with all other components of pricing stable. Were a trader to predict a modest upward movement in the cost of an equity according to a news release, he might purchase a call option, be correct in his assessment of price movement after the news, and still lose money. This could happen because the implied volatility DECREASES dramatically after the news release. Thus the drop in implied volatility will cause the utility of the option to fall, irrespective of price movement. The natural tendency of traders expecting such a move is to simply buy call options. This can be a difficult proposition with which to make money, because of the said issue of a decline in volatility. A trader should therefore note the current implied volatility of the option he is considering, and compare it to historical implied volatility, to asses the appropriateness of his trade.
Lets assume that you’re new trader and you follow a particular stock. That stock has traded in range for some time. However, you learn that the fundamentals are strong and you think it is very likely to go higher in the very near future. In addition, it is set to announce earnings in two days time. This, you think, is your opportunity. But what if the earnings are poor? You deem this an unlikely, but possible scenario. You simply cannot afford to take that risk. OPTIONS. You think of options. What a great idea. You will buy a call option, with the strike price at or near the current price. Your risk will be low you think. Your reward great if indeed, the earnings are good. So you buy the option. The earnings come, they’re better than expected, you look for your huge reward, but instead find almost no profit. How could this be? The answer is VOLATILITY…….in this case, Implied Volatility.
What you failed to recognize, as you purchased your call option, was that the cost of those options had been steadily rising in the days prior to your purchase. That rise was not fueled by price change of the underlying, or by a drastic change in the time component, and the strike price and interest rate were constant, the change was due to implied volatility. That simply means that, as a result of supply and demand, the pricing of the option had risen……IMPLYING…..a dramatic increase in volatility when there really was none. This implication was secondary to the anticipation of a move in price, rather than an actual move. Once the news was out that factor fell dramatically, and with it your profit. If you intend to trade options, you must understand their pricing, and the factors that affect that price.
For all intents and purposes, at expiration, your profit is dependant on the gap between where the stock price is and your option’s strike price.
Some professional traders make money by ‘selling Volatility ‘, or selling options when implied volatility is at its greatest. This USUALLY works. Long Term Capital Management found out that it doesn’t always work.
In order to accurately price an option, a trader must be able to predict not only price, but future volatility. That is a tall order.
It goes without saying that the cost of the option will also change as the strike price (or price at which the solution is to be exercised) changes. The nearer the strike, the higher the price. That price changes in a log fashion, however, and moving the strike out from the current price often doesn’t cause the cost of the option to fall as much as one might expect.
Time is also a great option pricing factor. Mark Cook once said to me that he would only hold options for three days. It only took me a couple of years worth of losses to understand why. The value of an option should be viewed as though it were a piece of ice, being held your hand. The longer you hold it, the less valuable it becomes. If you intend to purchase and sell options recognize this as of premium importance.
I will repeat what I have said before, that discipline is the clue to trading. Whatever your plan, whatever your strategy and tactics, you must pre define them and you must adhere to them. Most importantly, you must not forget that sometime you’ll be wrong, and you must incorporate this into your plan. The trader must be disciplined enough to have pre determined parameters for getting outside of the trade. This can be difficult with options. Charting the price of the option itself is rarely the proper approach. Instead, the underlying must be monitored. That would be the rationale for getting into the trade during the first place, so it also needs to be utilized as the trigger for getting out of the trade. A stop should be triggered by the underlying price moving to a look that makes the trade unlikely to succeed. The trader can then decide how, not whether, to step out of the option.
Online equity trading also gives the trader an opportunity to make much of the profit from day trade. Day trading is buying and the sale of financial stocks or shares within the same trading day such that all positions are usually closed before the market close for the trading day. Traders that participate in day trading are called as active traders or day traders. A keen observer can now make more profit sitting at home with the aid of online account.
Options can be worthwhile investment vehicles. However, you must seize the time to fully understand the elements that will have an impact on their pricing.
Green Mountain (GMCR.O) said late Wednesday Coca-Cola bought a 10 percent stake for $1.25 billion and would help launch Green Mountain’s new cold-drink machine, planned for release as soon as October. To be successful, many of the bets – call options conferring the right to buy Green Mountain shares at a specific price before midnight Friday – required the shares to rise to $90 or $95, roughly a 12 percent to 18 percent increase over two days. The shares, which closed …