October 8, 2006 1:22 AM
Basics of Stock Option Trading
Stock options are an excellent way to reduce risk in trading or to leverage your capital. While advanced stock option strategies are for experienced investors only, the basic option strategies can also be used by novice traders.
Basically an stock option is nothing complicated. There are just a few things to consider. There are two basic option types which are the call option and the put option.
The call (put) option gives you the right to buy (sell) a stock at a fixed price before a certain date, the expiration date. The option expires at this date and does no longer trade. Until this date your strategy should have worked out, otherwise your stock option expires worthless.
Buying the stock option is nothing else then buying the stock itself. Just that you need much less money to buy the option instead of the shares and that the option expires one day. But the rest is almost the same. When the stock moves, the option moves as well.
The difference and the big advantage of options is the leverage involved. To buy the option you need about 10% of the capital which would have been needed to buy the shares directly but with the same profit potential. There lies the risk as well.
One option contract equals 100 shares. If you want to own 1000 shares of Microsoft then you either can buy the 1000 shares at the stock exchange or you buy 10 Microsoft option contracts at the options exchange. You will figure out that there are many options for one stock. The reason is that options have different expiration dates and strike prices. The strike price is the price where you could buy the stock if you want.
In the praxis you don't want to buy the shares through the options so this remains a theory. Most options are not exercised but sold before expiration with a profit or expire worthless otherwise. So the option is just a bet with limited investment. You can never loose more than your option purchase price with the basic option strategies.
There are various combinations of covered and uncovered call and put options. Different strike prices and expiration dates have different option prices, leverage and risks. To learn the basic option trading strategies you must first explore the possibilities of simple call and put options.
Instead of a short sale you could buy a put option. Instead of going long in shares you buy a number of call contracts. Following the option prices for several days will show you that the option price decreases slowly although the stock price hasn't changed at all. This is the price you pay for the leverage.
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