Friday, November 30, 2012

Stock Option Trading Strategies

Stock options are derivatives whose values are based on the market value of a stock. When an option is sold, a contract exists between the seller, also known as the writer, and the buyer. This contract gives the buyer the choice of either buying from or selling to the writer the stock in question. Following is some more information about stock options and option trading strategies.

Security trading strategies are approaches to investment management that translate predictions about market direction into actual buying or selling of securities. Someone who thinks that a stock is going to go up in value is said to be bullish on the stock and would tend to take long positions, i. E., positions that will pay off if it goes up. If a person thinks that a stock will go down, they are said to be bearish. They will probably take short positions on it, ones that will reward decreases in its price.
A call option is a derivative that grants the buyer the right to buy a specific stock at a specific price called the strike price. The buyer pays a fee for this right. It is in effect for a specific time period and can generally be exercised at any time during that period.
If a person is bullish on a stock, then it would be reasonable for them to buy a call for that stock. A bull would expect the value of the stock to rise above the strike price before the option expires. By exercising the call, they will be able to buy the stock at a discount.
If a person is bearish on a stock then a possible strategy would be to sell a call on that stock. If the stock does go down as expected, the call will not be exercised, and the seller gets to keep the premium. If the call seller does not own the stock the call is referred to as a naked call. This is a very risky move. If it goes up a lot, the call will probably be exercised, and the seller will have to either buy it at a high price or give the call buyer an equivalent payment.
Put options are complementary to call options. A put grants the put buyer the right to sell a given stock to the put seller at a fixed price during a specific time period. Bulls sell puts and bears buy them.
There are many more complex and subtle variations on these four basic strategies. Everything can be derived from the basic principle of trading: buy low and sell high. For option trading this can be restated as go long on expected rising value, go short on expected falling value. Of course, with stock, the primary problem is knowing what it is probably going to do. This will be left as a problem for the reader. Once that has been determined, then one of the appropriate option trading strategies can be executed.