Internet Profits

Where are Options Traded?

2009-06-01T08:43:00.000-07:00

Option contracts are traded either;

on a public stock exchange (also known as ETO's (Exchange Traded Options))
implicity agreed between two parties (also known as OTC's (Over The Counter options)).

The majority of options, however, are traded via public exchange houses and these will be the options discussed throughout this web site. The OTC market is a complicated one, where traders from large institutions can create and trade non-standard option derivatives. They can, for example, add their own special rules such as: if the underlying stock trades as high as x then the contract terminates and the option is then worthless. This is known as a Knockout Option or a Barrier Up and Out Option.

Options are listed and standardized by the stock exchange and are traded by what is known as Serial Months. By standardized, I mean that the specifications that make up the option contracts are set by the stock exchange and cannot be changed.

Here is a snapshot of the August 2005 options for IBM.

The Call options are on the left, while the Put options are listed on the right. Notice the strike prices down the middle? In this case there are 24 contracts available for the public to trade that expire in August 2005. The total number of listed options for IBM at the time of writing (3rd July 2005) are 230. That's 115 call options and 115 put options.

Why Trade Options

2009-05-29T01:15:00.000-07:00

Option trading provides many advantages over other investment vehicles. Leverage, limited risk, insurance, profiting in bear markets, each way betting or market going nowhere are only a few. But let's look at a couple:

Leverage

One thing to note before we go on is that the buyer of an options contract pays an amount, known as the premium, to the option seller. An option seller is also known as the writer of the option. The option premium is simply the amount paid for the option - but there is more about this under the Pricing link.

When you buy an option contract from an option seller, you aren't actually buying anything - no asset is actually transferred until the buyer chooses to exercise. It is just an agreement where the buyer has the option to decide if the transfer is to take place. But the option contracts value is determined by the underlying asset - Microsoft Shares as an example.

Options give the buyer the right to buy a number of shares of the underlying instrument from the option seller. The amount of shares (or futures contracts) to buy is determined by;

The number of option contracts, multiplied by
The contract multiplier

The contract multiplier (also called contract size) is different for most classes of options and is determined by each exchange. In the US, the contract size for options on shares is 100.

This means that every 1 option contract gives buyer the right to buy 100 shares from the option seller.

So, if you buy 10 IBM option contracts, it means that you have the right to buy 1,000 IBM shares at expiration if the price is right (10 x 100).

Note: In other countries such as Australia, the contract multiplier for stock options is 1,000, which means the every option contract you buy entitles you to 1,000 underlying share contracts. So pay attention to the contract specs before you begin option trading.

This also means that the price of the option is also multiplied by the contract multiplier. For example, say in the above you purchased 10 options contracts that were quoted in the marketplace for 15c, then you would actually pay the seller $150.

This is a crucial concept to understand. If you go out and buy 5 IBM share options for 15c that have a Strike Price of $25, then you will;

Pay the option seller $75
If you decide to exercise your right and buy the shares, you will have to buy 500 (5 x 100) (100 being the contract size) shares at the exercise price of $25, which will cost you $12,500.

In this case, your initial investment of $75 has given you $12,500 exposure in the underlying security.

Option trading is very attractive for the small investor as it gives him/her the opportunity to trade a very large exposure whilst only outlaying a small amount of capital.

Say you bought a $25 call option for $1 while the underlying shares were trading at $26. If the market rallies to $27 the option must at least be worth $2 because you can exercise your right at $25. So, even though the shares only went up 3.8% you DOUBLED your money because you can now sell back the option for $2.

Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it is for Microsoft to trade from $25 to $50!

For this reason penny stock trading is becoming very lucrative for online speculators. They can still trade the stocks outright as well as making massive returns if they are correct about their view on market direction.

The only drawback with penny stocks is trying to pick which stocks to buy. I'm not that familiar with trading penny stocks, however, I know of a great site that provides stock picks for penny stocks every two weeks - . They have a free trial, so you can see for yourself whether penny stock trading is for you or not.

Penny stocks can be risky though - there's a reason why they're so cheap, nobody wants them! So, be careful to act on the right information.

Limited Risk

One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless. Let me give you an illustration.

Remember our initial example of Peter buying a Microsoft Call option? Here are the details of that trade provided with the appropriate jargon;

Underlying: MSFT

Type: Call Option

Position: Long (i.e. bought the contract)

Strike Price: $25

Expiry Date: 25th May

At the time of the trade, Microsoft shares (the Underlying) were trading around $30. The Call option contract had been valued and was trading at $6.5 - known as the premium, but more on this under pricing.

So, from the above information we can conclude that after the 25th May, if Microsoft is trading above $31.50 we can make a profit on this.

Why $31.50? Because we paid $6.50 for the right to have this option in the form of a premium to the option seller. This means we must consider this in our profit estimate. Therefore we add the option premium to the strike price to determine our break even point.

A profitable trade

If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise our right to Call the shares from the option seller. Then we will be assigned Microsoft shares at the exercise price of $25, which is the same as if we actually bought Microsoft shares for $25.

Note: If we exercise our right and take delivery of the shares, this means that we will have to pay the full amount for the shares. So, the number of option contracts bought multiplied by the contract size multiplied by the exercise price. If you are planning to hold onto option contracts until expiry and take delivery, make sure you have the cash!

But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares in your trading account with a purchase value of $25, yet they are trading at $40. So, you can sell them at $40 and make $8.50 per share.

Why $8.50? Remember the premium we paid? We have to consider that with our profit estimate.

Think about what happens as the underlying price continues to rise. You continue to make more and more money once the stock price has exceeded the strike price.

But what about the downside risk?

A losing trade

Let's imagine at expiration Microsoft shares are trading below our exercise price of $25 at, say, $20. Will we decide to exercise our right and take delivery of the shares and pay $25 per share? No way, because they're only worth $20.

So, we will just do nothing and let the option contract expire worthless.

What have we lost though? We lose the premium that we paid to the seller, which in this example was $6.5. That's it. A lot less than if the stock plummeted and we lost our entire investment.

What about if there is a stock market crash and Microsoft Shares are trading at $5 at the time of expiration? The same as if the shares are trading at $20 - nothing. We just let the option contract expire worthless and lose our premium - $6.5.

Limited Risk AND Unlimited Profit Potential

Can you see now how this type of strategy gives you the best of both worlds - both limiting your risk and at the same time leaving you open to make unlimited profit if the market rallies?

Not all option strategies have this payoff benefit. Only if you are buying options can you limit your risk. For option sellers, this is the reverse - they have unlimited risk with limited profit potential.

So, why would anybody want to sell options? Because options are a decaying asset, which you can read more about under the Time Decay section.

Insurance

Another reason investors may use options is for portfolio insurance. Option contracts can give the risk averse investor a method to protect his/her downside risk in the event of a stock market crash.

One example of this is called a Protective Put. You can read more about option trading strategies under the Strategies link.

Learn About Option Trading

2009-05-29T01:05:00.001-07:00

Option trading has many advantages over other investment vehicles. Trading in option contracts can give an investor the flexibility to place bets on very specific market outcomes.

For example, an option trader can make a bet that in 6 months time a stock will be trading either above a certain price or below a lower price - an each way bet if you will. If the stock trades between these two prices in 6 months, the trader will lose a predetermined amount. This type of option strategy is known as a Long Straddle or could also be a Long Strangle.

Option contracts also provide traders with an enormous amount of leverage. In the US, 1 option contract represents 100 underlying shares. In other countries, such as Australia, option contracts can be in multiplies of 1,000 times the underlying stock or commodity. So, with a relatively small amount of money an option trader can control a very large underlying stock position.

Because of this, option trading can also be a very risky venture for the inexperienced. Of course, option trading can make you very large returns in small amount of time, but trading options can also lose you the same amount if you are not careful.

Options101 was written to introduce new comers to option trading terminology. As you go through the basics you will be exposed to key terms that will become clearer as you progress through this short course in option trading.

Option Strategies

After you have become more familiar with the basics of option trading, why not take a look at some of the possibilities of Option Strategies. This section describes the main strategies used by investment professionals.

Option Pricing

I have also developed an option pricing spreadsheet that you can download for free. It prices European options using the Black and Scholes option pricing model and can also calculate all of the option greeks. You can also use it to test risk/reward profiles for various option strategies to help you better understand option trading.

Option Trading Tutorials

The tutorials section will go through actual examples of how to use options to make directional bets in stocks and futures. Even though the trades are hypothetical they are illustrated on a real time basis and updated frequently.

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2009-05-29T00:21:00.000-07:00

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First Posting About Internet Profits

2007-06-27T05:19:00.001-07:00

Internet is the larger's place to make profits online with internet we can make money with easily try it.