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Understanding Stock Option Trading | Financial Planning Tips

Understanding Stock Option Trading

Many traders think that stock options are nothing but stock substitutes with higher leverage and requiring less capital. After all, an option can be used to bet on the direction of the stocks to buy and sell the instrument at a specified strike price and date, just like an ordinary stock. But stock options have different characteristics, and strategies from ordinary stock and we will discuss these below.

In options, there are two positions: calls and puts. A call conveys the right but not the obligation to buy an instrument at a strike price before expiration. A put, would go the other route. It conveys the right but not the obligation to sell an instrument at a strike price before expiration. A “call” is a long position, while a “put is a short position.

Option Strategies and Terms

Option strategies are the simultaneous use of one or more options pertaining to buying and selling of a particular underlying stock. This is often done to maximize exposure and gain while mitigating much of the risk. Options strategies can be as simple as acquiring a put and call in the same stock, but they can also be quite complex.

The types of options strategies used can be bearish, bullish and neutral. The most interesting are the neutral strategies as these can be used to make money when you expect the price of a stock to not move much. This differs from traditional stock investments as you can’t profit from stock when the price doesn’t move.

  1. Bullish options– are strategies when the outlook on stock price trends are expected to increase. It is necessary to assess how high the ceiling will go upwards and the time frame in which the rally will occur, thus come up with the right strategy. Bullish traders usually sets a price for the bull run and utilize spreads to reduce the cost. Bull call spreads and bull pull spreads are examples of bull strategies. Mild strategies are option strategies to make money as long as stock prices does not go down drastically by the option’s date of expiration. This is sometimes called as writing out of the money covered calls.
  2. Bearish options– are strategies employed by the trader when he expects stock prices to go down. It is necessary to assess the situation on the stock’s downward spiral. The simplest bearish option strategy is the simple put buying strategy utilized by most novice traders. Bearish option traders usually take positions at set target prices of expected decline and utilize bear spreads to reduce the cost. Examples of strategies under this option would be: bear call spread and bear put spread.
  3. Neutral option strategies– strategies employed when trend in stock prices are not known by the trader, whether it will go up or down. The strategies employed here are sometimes called non-directional strategies. Examples would be:
    • Guts – sell in-the-money put and call
    • Butterfly – buy in-the-money and out of they money calls
    • Straddle – hold both call and put positions at the same strike price and position
    • Strangle – simultaneous buy and sell position of out-of-the-money put and call with same expiration
    • Collar – buy put option below current price; sell at current or above market price
    • other terminologies like fence, iron butterfly and iron condor that involves buying and holding of different options under neutral situations.

Now you know a bit of the basics involved in understanding options. Hopefully you will dig a little deeper into the topic and employ some of the above strategies to accelerate the earnings in your portfolio.

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