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CRITICAL SUCCESS FACTORS FOR TRADING STOCK OPTIONS

By: Billy Williams..

Stock options are a misunderstood investment tool but once understood by both traders and investors it can be a very versatile investment tool. However, as a consequence of their versatility, options are often viewed as to complex for the beginning option trader to utilize effectively. In order to avoid common mistakes of the beginning traders or investors it's important to understand a few basic concepts like types of options offered, leverage, risk control, time, and strike prices.

It is vital that you understand that there are two types of options that are commonly available on exchange traded companies are called "calls" and "puts". Calls are purchased when an option investor believes that the underlying instrument, or stock price in this case, is about to rally and go higher. Put options, however, are purchased when a particular option investor believes that the share price on the company is about to fall and go lower. Once you understand the directional bias of each option alternative you understand more effectively your available choice when speculating on the direction of the stock you are analyzing.

The second factor to understanding stock options is that they offer one of highest sources of leverage by allowing you to control blocks of 100 shares per each option. For example, if you bought 100 shares of a $60 stock then you would have $6,000 invested but you would only need a few hundred dollars to control the same position with options. If your $6,000 worth of stock rose from a share price of $60 to $72 and you sold then you would realize a gain of 20% or $1,200. But if you owned call options on the same position you could conceivable earn a 200% or 300% gain!

By now, you are beginning to understand the profit potential that stock options offer you with this kind of leverage yet when you factor the ability to control risk with options you really begin to realize their potential. If you purchased 100 shares of a $50 stock or $5,000 on a given company and suddenly the company's CEO announced the company's bankruptcy you could see your investment go to zero. But, if you instead just bought call options on the stock the most you could lose is the few hundred dollars you purchased the option with. Having the ability to limit your risk is critical to your financial well-being especially if disaster strikes as in this example.

Stock options offer you an enormous advantage in profiting from the markets you must understand the concept of time in how it applies to option trading. Though they vary a bit, stocks offer different types of options with different time periods on them. These time periods, or what is commonly referred to as expiration periods, range from 30 days out to as long as 3 years with expiration days occurring every third Friday of calendar month. In my opinion, it is vital for you to understand the average holding days for your option trades so that you purchase the proper option so that it has enough time on it so you have time to profit from you position. If the average holding period is seven days and it is the middle of the month then purchase the next month's options so that you have 2 weeks plus another month in order to give your option position enough time to profit. Any option under 30 days till expiration is rapidly disintegrating in value due to time decay.

The other critical concept you must understand when trading options is what strike prices are and how to use them. "Strikes" are the set price terms assigned to a given underlying instrument or, in this case, to the stock of a publicly traded company. As an example, XYZ company's stock is at $70 a share and its call options are listed at a $65 strike, $70 strike, and $75 strike. Each strike has its advantages depending on your option trading method but knowing what strike prices are offered and understanding them in relation to option trading will help you make the best trading decision on which stock option to select.

Understanding stock options and their role in your investment choices provides you with enormous potential for high returns as well as limiting your risk. There flexibility allows you to potentially profit from rising markets, falling markets, markets that are range bound, and protecting your stock portfolio from unexpected volatility in the markets. Take some time and reread this article as well as similar articles along with studying any financial newspaper that offers price option tables. The time you invest in understanding these powerful investment tools can help you take advantage of their enormous potential and improve your bottom line.

Article Source: http://ezine-articles-planet.com

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