Learn Options Trading - Stock Options Help

Before you learn the basics about how to trade options and the strategies, it is important to understand the types, cost and risks before opening an options account for trading. This article will focus on stock options vs. foreign currencies, bonds or other securities you can trade options on. This piece will mostly focus on the buy side on the market and the trading strategies used.

What is a Stock Option

An option is the right to buy or sell a stock at the strike price. Each contract on a stock will have an expiration month, a strike price and a premium - which is the cost to buy or short the option. If the contract is not exercised before the option expires, you will lose your money invested in your trading account from that contract. It is important to learn that these instruments are riskier than owning the stocks themselves, because unlike actual shares of stock, options have a time limit. There are 2 types of contracts. Calls and Puts and How to trade them and the basics behind them.

What is a Call Option and how to trade them?

A call option contract gives the holder the right to buy 100 shares of the stock (per contract) at the fixed strike price, which does not change, regardless of the actual market price of the stock. An example of a call option contract would be:

1 PKT Dec 40 Call with a premium of $500. PKT is the stock you are buying the contract on. 1 means One option contract representing 100 shares of PKT. The basic thought and learning how to trade call options in this example is you are paying $500, which is 100% at risk if you do nothing with the contract before December, but you have the right to buy 100 shares of the stock at 40. So, if PKT shoots up to 60. You can exercise the contract and buy 100 shares of it at 40. If you immediately sell the stock in the open market, you would realize a profit of 20 points or $2000. You did pay a premium of $500, so the total net gain in this options trading example would be $1500. So the bottom line is, you always want the market to rise when you are long or have purchased a call option.

Trading Strategy vs. Exercising and Understanding Premiums

With call options, the premium will rise as the market on the underlying stock rises. Buyer demand will increase. This increase in premiums allows for the investor to trade the option in the market for a profit. So you are not exercising the contract, but trading it back. The difference in the premium you paid and the premium it was sold for, will be your profit. The benefit for people looking to learn how to trade options or learn the basics of a trading strategy is you do not need to buy a stock outright to profit from it's increase with calls.

What are Put Options?

A put option is the reverse of a call contract. Puts allow the owner of the contract to SELL a stock at the strike price. You are bearish on the shares or perhaps the sector that the company is in. Since selling a stock short is extremely risky, since you have to cover that short and your buyback price of that stock is unknown. Bet THAT wrong and you are in a world of trouble. However, put options leave the risk to the cost of the option itself - the premium. Learning or getting information on how to trade Puts starts with the above and looking at an example of a put contract. Using the same contract as above, our anticipation of the market is completely different.

1 PKT Dec 40 Put with a premium of $500. If the stock declines, the trader has a right to sell the stock at 40, regardless of how low the market goes. You are bearish when you buy or are long put options. Learning to trade puts or understanding them starts with market direction and what you have paid for the option. Any basic strategy you take on this contract must be done by December. Options normally expire toward the end of the month.

You have the same 3 trading strategy choices.

Let Option Expire - usually because the market went up and trading them is not worth it, nor is exercising your right to sell it at the strike price.

Exercise the Contract - Market declined, so you buy the stock at the lower price and exercise the contract to sell it at 40 and make your profit.

Trading The Option - The market either declined, which raised the premium or the market rose and you are just looking to get out before losing all of your premium.

Conclusion Basics

Trading Options carries nice leverage because you do not have to buy or short the stock itself, which requires more capital.

They carry 100% risk of premiums invested.

There is an expiration time frame to take action after you buy options.

Trading Options should be done slowly and with stocks you are familiar with.

I hope you learned some of the basics of options buy side trading, investing and how to trade them. Look for more of our articles. American Investment Training.

TRADING OPTIONS SPREADS

A spread is created when a long and short position is taken on a type of option. Calls are one type and puts are another. Thus you can only have a call spread or a put spread. Long and short calls and the same on puts. The idea on a spread is to profit on the premium difference bought and received or on the movement of the market to trigger action on the options themselves - either through a trade or exercising them.

Debit Call Contracts

Spreads that are created when the premiums bought and sold results in a loss for the options trader is a debit spread. This would mean the investor needs the contracts to perform well to make the debit up. Debit spreads can be bullish or bearish.

Strategy Example

Buy 1 LTD Nov 40 Call for $300

Short 1 LTD Nov 50 Call for $100

These call options that were bought and sold resulted in a debit for this trader. The debit is $200. The options investor is looking for these contracts to become more valuable so they can be traded or exercised. The "spread" profit potential is in between the strike prices. When creating call debit strategies, the investor is bullish on the market. The market rising on this stock is what is needed for this trading position to be profitable going forward. The maximum loss is the $200 debit - should the contracts expire.

The above would also be considered a Bullish spread because the investor is looking for the market to rise and trigger action on the options. When a spread trader loses on the premiums (difference between the contracts bought and sold) - he or she needs movement on the market to create a trading opportunity.

Debit Spreads

Good trading to you! American Investment Training

Nick Hunter is the Training Director for American Investment Training. AIT provides trading courses and information on Option Spreads.

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UNDERSTANDING BOND YIELDS - YIELD TO MATURITY

Bonds are quoted based on several indicators. Price, coupon rate (nominal yield), call yield (if callable) and yield to maturity. Each of these will effect the value of the investment. The yield to maturity is the overall rate of return, over the life of the bond based on many of the factors above.

Premium

A fixed income security is sold based on current interest rates vs. the interest rate on the bond. This difference is why bonds are sold at premiums (above par) and at a discount (below par). If a security has a nominal yield of 6%, but current interest rates on similar bonds are at 5% - the bond will be priced at a premium. This will result in a lower yield to maturity than the nominal rate of 6%.

Because bonds are fixed securities, the 6% rate cannot be changed, thus brokers and traders will re-price bonds to reflect the current interest rate environment. Since interest rates are at 5%, the bond will be priced to yield near 5%. The fixed coupon is paid to par value only. So, based on one bond ($1,000 par), the investor will earn $60 per year in interest - regardless of the price paid for the bond. The premium never earns interest. The customer will also only get par at maturity. The yield to maturity will be lower because they are investing over par for the bond, but only getting interest on par and getting par at maturity. That loss of premium price over the life of the bond, coupled with the interest will give the bondholder a lower overall YTM at the end.

Discount

Fixed income bonds sold at discounts will have the opposite effect on yield to maturity. Since discount securities have a lower coupon rate than current interest rates, the yield to maturity will be higher than the nominal rate. If a bond is at 5% is sold at $950, the YTM will be greater than 5% because the investor is earning 5% on $1000, when he only invested $950 and he will get $1000 at maturity. The yield grows because of the coupon earned and the accreted discount of $50 earned throughout the life of the investment.

Par

Debt bought at par will have a YTM equal to the nominal yield because no premium or discount was paid. A 6% security bought at par will yield 6%.

Callable

Bonds that are callable can be lower or higher than the YTM based on the call price that the security is redeemed early at and the time of the call event or date. Typically, fixed income investments that are bought at a premium will have a lower yield to call, because the premium cost is lost sooner. A discount debt instrument will normally have a higher yield to call, since the discount gain is paid off to the investor sooner - and prior to maturity.

Nick Hunter is the President of American Investment Training. AIT provides training to the financial profession and has a FREE online investment glossary that helps traders, brokers and individual investors. More On Bond Yields

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