Basic Concepts Required in Option Trading Strategies

July 15, 2009 by  
Filed under Options Trading

Many simple strategies exist in basic stock option trading, but there are some general concepts you’ll need to understand in order to continue your options trading education.

If you don’t know what a call or put is, it’s time you learned. Investing in a call option does not obligate you, but gives you the right to buy at a pre-determined price. Conversely, puts give you the right to sell at a specified price. You’ll have the ability to buy or sell options, and when selling you transfer this right to the buyer of the option.

Long calls are the most basic types of calls. As an example, a stock market price may be $30, and have April 15 options that expire on the third Friday of April. The strike price is a pre-determined $15 that essentially means that if exercised, the option must be bought at $15.

Short, or naked calls, apply to situations where the seller of the option does not own the asset he must sell if he exercises his option. On the selling side of the transaction, this position is said to be ‘short’.

When market prices decrease, short calls profit by the amount of the premium. When this price increases and reaches a level above the strike price by an amount greater than the premium paid, the short position loses.

A long put is used when investors believe the future market price of the underlying asset will drop before the expiration date. Profits are pocketed when prices fall below the strike price by an amount greater than the premium. When prices increase or don’t fall enough, the put contract is typically allowed to expire at a loss.

For those who think future prices will rise, a common options trading strategy is selling the right to sell at a pre-set level. When the underlying asset’s market price increases, a short position buyer will profit the amount of the premium. When the price dips below the strike price by at least the amount of this premium, the investor loses.

These four basic positions are utilized in several different strategies in a variety of combinations. When trading options, these strategies may be employed to strictly make a profit, or try to manage risk with hedging.

Hedging basically means that an options trading investor takes two positions that typically move in opposite directions; this method results in lower profits, but will help to protect against huge losses and maintain profits that are realized.

‘Bull spreads’ and ‘bear spreads’ are used to achieve this goal. Bull spreads use the long calls we discussed above with lower strike prices, and combine these with short calls at higher strike prices, and a short put with a higher strike price. Bear spreads use a short call at a low strike price, long call with a high strike price, or a short put with a low strike price and long put with a high strike price.

Your online options trading software will help you to learn about these strategies using examples and supposed parameters and assumptions.

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