US Options Trading Part 2

Confused yet? This post was part of a 12-part series that I wrote many moons ago on the old blog. The contents is still valuable, just don't be thrown by the 12 days of Christmas.

On the the Third Day of Christmas I gave you a very quick and brief introduction to options trading, if there we're any gaps or anything you didn't understand feel free to chime in with a comment. Part 1 was an attempt to spark your interest; this post is to show you the mechanics of how it works. Again, there'll be plenty of screenshots that enlarge when you click them, so this article is best viewed online.

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Before we dive into the details, a small disclaimer: If option trading isn't your thing or the details get a bit heavy, feel free to read a different post. Now on to the practical, I'll show you a process from start to finish, what you can expect if you use an online broker, a comparison between options and shares and a couple of case studies: one of a successful options trade, and one that wasnt' so successful! (Losses are referred to as learning experiences or donations to the market)

In the last week of trading I've said goodbye to a trade that I had stuck with through thick and thin (it was like saying goodbye to an old friend!). The next day I had the joy of the $1,200 windfall and I was briefly acquainted with ENER (Energy Conversion Devices Inc.) before it dropped, hit my pre-determined stop loss and my trade was cancelled.

The US Market

So let's start from the start, obviously. I trade the US market as there are more stocks, and more importantly more stocks with options attached to them. (Options aren't available on all stocks) Also, the US market has more participants (buyers and sellers) so there are more stocks that are liquid .

Finding a Profitable Stock/Company/Option

All publicly listed companies put out an earnings report every quarter, this data is made available online (and to you and me) via several online stock screeners. Some of the more popular ones are yahoo, MSN Money and more recently I've been experimenting with Finviz. Plenty of information is available on combinations of financial criteria to use in your choice of screener, it's a whole other article to explain the definitions of each criteria I use but the image below is an example of a screen that I use.

Reviewing Profitable Opportunities

The selection criteria I use identify profitable companies that are under valued or have taken a down turn in the last 12 months. From the screener I'll look into each company, see if there's any relevant news, upcoming announcements or see if they have taken a drastic dive and a due to slowly return to their previous 52-week high.

Options versus Shares

As an example, today Google is trading at $596 a share. Now remember from the Third Day of Christmas that an option has three components, the strike price, expiry and premium. If you wanted to have the option to buy Google for $600 up until June next year, you'd pay $44.20 for this option. For less than 10% of the cost of the share you have the right to buy Google at $600 up until June 2010. If Google went up to $1,000 you'd have the right to buy it for $600, realizing $355.80 profit ($1000 $600 $43.50 = $355.80) Check out the options chain below to compare strike prices and premiums for yourself.

Winners are Grinners

Ill use a profitable trades as an example. Once I've done my screen, confirmed the company is profitable, investigated the news or it's past performance, any outstanding factors etc. I'll select my combination of expiry month, premium and strike price. Upon placing an order and having it confirmed, I'll then place 3 more contingent orders. One as a stop loss to sell all of my option contracts if the stock moves down (or the opposite direction I've anticipated), a break even price that gets my initial investment off the table & sells 1/3 of my contracts, a profit target that sells another 1/3 of my contracts and credits me with some profit and then finally 1/3 of my contracts are still live and have the capacity to increase in value.

The image on the left is of Astoria Financial ( AF ). When AF was trading at $9.40 I bought an option on AF to buy at $10 ( strike price ), this cost me a premium of $0.99 and lasts until April 2010 ( expiry ). Since then AF is trading at $11.86, the premium I purchased is worth $2.10. Let me repeat this, it's important the stock went up to $11.86 from $9.40 (26%), the option premium increased from 99 cents to $2.10 (111%). Ok so the stock went up by about ten percent, but by using the leverage of options, I doubled my money .

An Expensive Lesson

I've been playing with options for the past few months and virtual traded for a few months prior to that, so I'm still in a teething process myself and developing my own rules to trading, with the main goal to preserve my capital and manage risk.

As I mentioned before, I put a contingent order on a stock as a stop loss, if the stock/option goes belly up, I'll be stopped out of the trade, take a small loss and move onto another stock. The leverage I've outlined above (26% versus 111%) also applies to a loss! I put one of my first stop losses on the stock, so while the stock didn't reach my stop loss of 10% the option premium plummeted to nearly zero! I held onto this stock and luckily the price moved right back up, at this point I could place a new contingent stop on the option premium.

One day after this stop bounced back up to the tune of $850, the next day it dropped back down! As I had a stop loss on the premium I took only a small loss and exited the trade.

Try It Yourself

Now this post has been a bit heavy in detail but don't let that scare you! The leverage of options and the opportunities out there are too many to ignore. Start small, get onto an online broker and start a virtual account for free and start experimenting. Obviously there's a lot more to trading options that I've been able to fit in two posts on the site.

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Posted in Health and Medical Post Date 12/09/2017






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