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Wednesday, February 02, 2011 10:47:02 AM
What I have learned playing options
I want to first premise by saying a couple of things. First, this is in no way shape or form me telling you to play options. Options are extremely risky and only you should know what your level of risk is. I have had a few people ask me to post about my experience in options, so this is just an informational post. Second, I am a short term trader. I have a set of rules that I stick by and I highly suggest that you should stick by your own. If you don't already have a set of rules, I highly recommend that you create some. Third, options is like a roller coaster. If you don't have the stomach for it, I highly suggest that you probably not do it.
A small tidbit of background on me. For the last couple of years I was in the penny stock market. The idea of being able to get a couple of bags in one day was highly attractive to me. After being on the roller coaster for quite some time, I decided that I wanted to find another alternative, one that was more consistent. I'm a techincal trader and I wanted to play something that followed the charts on what I was seeing. In the penny market, if someone has a bunch of money, they can manipulate the stock. You can do it on big boards, but someone needs to have millions and millions of dollars going in or out of the stock to have the same effect that 100k would have on a sub-penny.
Ok, so let's get to the options. I believe that the best way to describe options can be summed up in one sentence. "Options is the market in which you turn a big board stock into a penny stock." Options reflect what the price of the stock is doing but on an exponential form (i.e. the stock could be up 2% but options could be up over 100%). There are several variables that come into play when dealing with options. These are the key things that you need to know before you venture into the arena.
One of the most important things. If you don't know how to read a stock chart, then you are not ready for options. You must not only understand charts but also be good at predicting which way the stock is going to go. Options is all about entry price. You want to get the best entry price possible. But you also want to know where the support / resistance levels are so you know if you should cash in and lock profits or let it ride. There are some great free lessons out there on how to read charts, I highly suggest that if you do not know how to read a chart that you learn. It will come with experience on watching the charts and level 2 to be a step ahead of everyone to get the right entry and exit prices.
1) Contracts. When you make a purchase in the options arena, you are buying contracts. One contract means that you are buying 100 shares of a particular stock. You pay comission both on the trade and the amount of contracts you are purchasing. Hypothetically, say you bought 10 contracts @ .10. The broker will charge you the comission to execute the trade but also a cost per contract. TD Ameritrade charges 9.99 for the comission + .75 per contract. Therefore, 9.99 + 7.50 (10 contracts x .75 per contract) = 17.49 to execute the trade. See with your broker what the comission rates are as they vary across the board.
2) Strike Price. Whether you are putting in a call or put, strike price is what you need to figure out first. A call is betting that the stock is going to go up. A put is betting that the stock is going to go down. The strike price is the price in which the stock needs to get to for you to be in the money. Not all strike prices are in the money. The further outside the money a strike is, the higher the risk. What is "being in the money" you ask? Well for example, General Electric (GE) is currently trading at the price of $20.79. A call strike price of $21.00 is not in the money. The reason that it is not, the stock has not reached $21.00 yet. However, a call strike price of $20.00 is in the money. This means that when a stock expires (we will cover that next) if the stock closes at $20.99 on the day of expiration, if you are holding a $21.00 strike call, you lose every single dollar you have. But if you hold $20.00 calls, you will receive .99 on the expiration date. If you are in the money, the contract is worth the amount above the strike price you are in. In the example above, if the stock was $21.50 at expiration and you held $20.00 calls you would be paid $1.50 per contract, and for $21.00 calls $.50 per contract.
3) Expiration. Expiration plays a huge key factor into what you think will happen with the stock. The closer the expiration date, the riskier the option. As days go by and the expiration date gets closer, the riskier the option gets as well. This means that if the expiration date of an option you are going to buy is 30 days away, you have some time to play with. However, if it is 2 days away, your window of time is very close to closing. If you are very far outside the money, the option you are holding will probably be worth almost nothing at that point. The further outside the money your option is (or even inside the money) and the closer the expiration date gets, if the stock is not doing what you predicted it will do, the value of the premium will go down. The value of the premium means what the option is worth at a particular price of the stock. An option could be worth $1.00 when a stock is $20.50 on a $21.00 call if the expiration date is 30 days away. However, if the expiration date is 2 days away and teh stock is $20.50, that same $21.00 call the option could be in the neighborhood of $.12 - .15. You see the difference? The value of the preimum went down dramatically. For you to break even on your purchase price of $1.00 you must have the stock hit that $21.00 mark before your expiration date in 2 days.
4) Volume. One of the biggest drawbacks of options is that not every stock has options or if they do there isn't much volume. I highly suggest that if you are looking into the venue of options, that you find ones that have large or even decent volume. This means that there is liquidity in these options and you can buy and sell them as you choose. If you buy options that have say a total volume of 50 for the day, well it will take a lot longer to sell those options for profit then say BAC who averages 20,000 a day (on just one strike price). If you find a stock you like, just take a quick look at the option chain. This will give you the calls and puts of a particular expiration date. See the picture below for an example of a good and bad volume option play.
Good - BAC
Bad - FDO
Bank of America vs Family Dollar Stores. As you can see theres a ton of liquidity in BAC and not so much in FDO. I personally would stay away from FDO as I like high volume options. But this is my preference, you make like it differently.
5) High Frequency Traders. When you play options, you are mostly playing against computres. You are playing against computers that will change their bid x ask price in a split second (literally). One second you will have a ton of support on the bid, the very next second it could completely disappear (literally one second later). This is why it is crucial, if you are a daytrader, to be able to read the chart and recognize the trends and patterns of what is to come. If you cannot recognize it, you will have a tough time maximizing profits. You can use this to your knowledge though and cash in before they completely go the opposite way of what you are predicting.
6) Comfort Level. Do what works for you. If you are not comfortable doing it, then I highly suggest staying away. This was just a very brief rundown as there is so much that you have to take into consideration when playing options. I hope this gives a brief overview of those of you that have expressed interest in the venue. Remember, it's not for the faint of heart.
My suggestion that before you ever put one dollar into the option world, just watch a few stocks on level 2 and watch their options on level 2 as well. Watch how the price of the options fluctuate as the price of the stock does. Watch what happens to the options when the stock approaches daily resistances / supports as well as intraday resistances and supports. Get familiar with the types of fluctuations so you aren't going in blindly.
If you have any questions, as always please ask on the ATM board.
Good luck and Happy Trading!
AH
I want to first premise by saying a couple of things. First, this is in no way shape or form me telling you to play options. Options are extremely risky and only you should know what your level of risk is. I have had a few people ask me to post about my experience in options, so this is just an informational post. Second, I am a short term trader. I have a set of rules that I stick by and I highly suggest that you should stick by your own. If you don't already have a set of rules, I highly recommend that you create some. Third, options is like a roller coaster. If you don't have the stomach for it, I highly suggest that you probably not do it.
A small tidbit of background on me. For the last couple of years I was in the penny stock market. The idea of being able to get a couple of bags in one day was highly attractive to me. After being on the roller coaster for quite some time, I decided that I wanted to find another alternative, one that was more consistent. I'm a techincal trader and I wanted to play something that followed the charts on what I was seeing. In the penny market, if someone has a bunch of money, they can manipulate the stock. You can do it on big boards, but someone needs to have millions and millions of dollars going in or out of the stock to have the same effect that 100k would have on a sub-penny.
Ok, so let's get to the options. I believe that the best way to describe options can be summed up in one sentence. "Options is the market in which you turn a big board stock into a penny stock." Options reflect what the price of the stock is doing but on an exponential form (i.e. the stock could be up 2% but options could be up over 100%). There are several variables that come into play when dealing with options. These are the key things that you need to know before you venture into the arena.
One of the most important things. If you don't know how to read a stock chart, then you are not ready for options. You must not only understand charts but also be good at predicting which way the stock is going to go. Options is all about entry price. You want to get the best entry price possible. But you also want to know where the support / resistance levels are so you know if you should cash in and lock profits or let it ride. There are some great free lessons out there on how to read charts, I highly suggest that if you do not know how to read a chart that you learn. It will come with experience on watching the charts and level 2 to be a step ahead of everyone to get the right entry and exit prices.
1) Contracts. When you make a purchase in the options arena, you are buying contracts. One contract means that you are buying 100 shares of a particular stock. You pay comission both on the trade and the amount of contracts you are purchasing. Hypothetically, say you bought 10 contracts @ .10. The broker will charge you the comission to execute the trade but also a cost per contract. TD Ameritrade charges 9.99 for the comission + .75 per contract. Therefore, 9.99 + 7.50 (10 contracts x .75 per contract) = 17.49 to execute the trade. See with your broker what the comission rates are as they vary across the board.
2) Strike Price. Whether you are putting in a call or put, strike price is what you need to figure out first. A call is betting that the stock is going to go up. A put is betting that the stock is going to go down. The strike price is the price in which the stock needs to get to for you to be in the money. Not all strike prices are in the money. The further outside the money a strike is, the higher the risk. What is "being in the money" you ask? Well for example, General Electric (GE) is currently trading at the price of $20.79. A call strike price of $21.00 is not in the money. The reason that it is not, the stock has not reached $21.00 yet. However, a call strike price of $20.00 is in the money. This means that when a stock expires (we will cover that next) if the stock closes at $20.99 on the day of expiration, if you are holding a $21.00 strike call, you lose every single dollar you have. But if you hold $20.00 calls, you will receive .99 on the expiration date. If you are in the money, the contract is worth the amount above the strike price you are in. In the example above, if the stock was $21.50 at expiration and you held $20.00 calls you would be paid $1.50 per contract, and for $21.00 calls $.50 per contract.
3) Expiration. Expiration plays a huge key factor into what you think will happen with the stock. The closer the expiration date, the riskier the option. As days go by and the expiration date gets closer, the riskier the option gets as well. This means that if the expiration date of an option you are going to buy is 30 days away, you have some time to play with. However, if it is 2 days away, your window of time is very close to closing. If you are very far outside the money, the option you are holding will probably be worth almost nothing at that point. The further outside the money your option is (or even inside the money) and the closer the expiration date gets, if the stock is not doing what you predicted it will do, the value of the premium will go down. The value of the premium means what the option is worth at a particular price of the stock. An option could be worth $1.00 when a stock is $20.50 on a $21.00 call if the expiration date is 30 days away. However, if the expiration date is 2 days away and teh stock is $20.50, that same $21.00 call the option could be in the neighborhood of $.12 - .15. You see the difference? The value of the preimum went down dramatically. For you to break even on your purchase price of $1.00 you must have the stock hit that $21.00 mark before your expiration date in 2 days.
4) Volume. One of the biggest drawbacks of options is that not every stock has options or if they do there isn't much volume. I highly suggest that if you are looking into the venue of options, that you find ones that have large or even decent volume. This means that there is liquidity in these options and you can buy and sell them as you choose. If you buy options that have say a total volume of 50 for the day, well it will take a lot longer to sell those options for profit then say BAC who averages 20,000 a day (on just one strike price). If you find a stock you like, just take a quick look at the option chain. This will give you the calls and puts of a particular expiration date. See the picture below for an example of a good and bad volume option play.
Good - BAC
Bad - FDO
Bank of America vs Family Dollar Stores. As you can see theres a ton of liquidity in BAC and not so much in FDO. I personally would stay away from FDO as I like high volume options. But this is my preference, you make like it differently.
5) High Frequency Traders. When you play options, you are mostly playing against computres. You are playing against computers that will change their bid x ask price in a split second (literally). One second you will have a ton of support on the bid, the very next second it could completely disappear (literally one second later). This is why it is crucial, if you are a daytrader, to be able to read the chart and recognize the trends and patterns of what is to come. If you cannot recognize it, you will have a tough time maximizing profits. You can use this to your knowledge though and cash in before they completely go the opposite way of what you are predicting.
6) Comfort Level. Do what works for you. If you are not comfortable doing it, then I highly suggest staying away. This was just a very brief rundown as there is so much that you have to take into consideration when playing options. I hope this gives a brief overview of those of you that have expressed interest in the venue. Remember, it's not for the faint of heart.
My suggestion that before you ever put one dollar into the option world, just watch a few stocks on level 2 and watch their options on level 2 as well. Watch how the price of the options fluctuate as the price of the stock does. Watch what happens to the options when the stock approaches daily resistances / supports as well as intraday resistances and supports. Get familiar with the types of fluctuations so you aren't going in blindly.
If you have any questions, as always please ask on the ATM board.
Good luck and Happy Trading!
AH
No matter how big or how small...Green is Green :-)
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