Trading Options Question

[Lou]

Im trying to read as much as I can about trading options. I've never traded them. The question I have is, is the best or safest type of options trade one that you buy a option that the strike price is lower than the current equity price? Reason being is the lower strike price guards you in case the equity share price falls. any help or scenario's would be appreciated.

[spanky]

Lou,

I don't trade options either, but Cramer's Real Money book talks about them briefly. The trick to options is that you pay more for options with a lower strike price (since the likelihood for the stock price exceeding the strike price is higher). So you need larger gains before your option will pay off. If you choose an option with a higher strike price, the cost of the option is smaller, and the price doesn't have to exceed the strike price by as much before you are in the black.

The cost of the strike price is also a function of the timeframe that you choose, also. For example, you buy options for XYZ with a closing price today of $100. The cost of a Feb120 call options would be less than for Nov120 call since it's less likely to grow $20 in price by Feb 07 than by Nov 07. but if the price does climb $20 by the third friday in Feb 07 (when the Feb 07 options expire), you could exercise the option and make a lot of cash!

If you make the timeframe the same for XYZ and make the basis $80 (with today's close on XYZ being $100), then the cost of the call will be quite large, and the stock price will have to climb like mad before you get any payoff.

Like anything else, it's all a matter of your personal risk profile, and you need to be fairly certain that you see something in the valuation of XYZ corp that the other analysts have missed, otherwise the likelihood of hitting paydirt on the option shrinks.

If I got any of this wrong, I'm sure others will pitch in and help me where I messed it up -- but that's my understanding.

Spanky

[aiki14]

Spanky you have it correct.
The safest way to play options is to buy (be Long) calls or puts, the risk is only the premium. Selling (being short) has potentially unlimited risk and is for advanced and well funded players.
Technically selling way out of the money calls or puts is the safest (in terms of upside/downside risk) play but the one time it goes bad you're in that unlimited loss situation.

Lou, You have to state whether you're in Calls or Puts. There should be no difference in the profit no matter what the stock price to strike price ratio is. (It doesn't work out thyat way exactly for complicated reasons but its close)
example
A jan 25 xyz call at 1.00 (read xyz corp call option due january is $100)
and
A jan 20 xyz call at 6.00 are of equal value if the stock price is 30

the Stock price + the premium = break even (on calls)

So both the above positions would be $4 up ($400 really since the leverage is 100 to 1)

I hope this helps.

[Lou]

Your right. I was talking about calls, but you say either calls or puts is good with this scenario. I'll be asking more questions - thanks again.

[Svenwulf]

a few days old, but not much on cnbc and the rest about it. any one care to venture possible outcomes? good luck.

TRADING FLOOR SECRETS: New Margins
Tuesday, January 09, 2007

by Scott Kramer of Optionetics.com

At the risk of hyperbole, one of the most substantial, beneficial and powerful rules to be implemented in the financial markets will take effect officially on April 2, 2007, though not every broker will be up to the challenge that early.

The Chicago Board Options Exchange [CBOE] and Securities and Exchange Commission [SEC] has approved revised margins on stocks that are protected by options contracts. Under the terms of the new rules, investors who have a stock position that is protected by options contracts will have the potential to have their margin reduced to their actual risk. Up until now, anyone wanting to purchase stock on margin, even if utilizing a protective put for insurance purpose, had to put up ½ the stock's value, even if they could not lose that value.

Old Margin

A "put" option is a legally binding contract traded on many exchange floors that allows the owner the right (but not the obligation) to sell a specified amount of stock at a specific price prior to the contact's expiration date. Working just like homeowners' insurance, should your stock burn down you will be compensated for the loss at the insured value (strike price) minus the current stock price. If you owned the 100 strike put and the stock fell to $60 (from $101 a share), your put insurance policy would allow you to collect the $40 lost in the stock fire. Your loss will be the $1 per share difference between the stock price and the strike price plus the cost of insurance, but this is substantially less risk than an unprotected stock, or even the current 50% margin.

If the put insurance cost you $2 per share, then your total risk would be $3 ($2 for the put and $1 stock risk). Under current margin rules you would have to put up the cost of the put and 50% of the stock value. If you wanted to purchase 1,000 shares of stock for $101 the $101,000 stock position would be margined at $50,500. Since each put option hedges 100 shares of stock and costs $2 per share, your insurance will cost an additional $2,000, for a total investment of $52,500.

New Margin

The new margins will allow investors and traders to reduce the $52,500 margin down to $3,000. Recall from above that the most one can lose on a hedged stock is the difference in price between the stock price ($101) and the strike price ($100), with the cost of the put ($2 per share) as additional risk. Since this comes out to be a total of $3 per share real risk the new margin rules will allow for many people to only have to put up the $3 per share, or $3,000 on the position described. This is POWER and leverage in the same league (or many instances greater) as commodities futures.

What This Means To You

For most people new to investing in either stocks or options, capital requirements tends to be the biggest obstacle after knowledge. With enough knowledge, hopefully capital eventually ceases to be an issue, so I stress knowledge as the number one obstacle that traders experience. We at Optionetics are doing all we can to fill this void, so I am focusing on how this new rule helps overcome the other problem new investors face: capital shortage. When I ask people to name a stock they would like to put a bullish or bearish position on in, they inevitably throw out names like GOOG, CME, etc. They want to play stocks that can move $5, $10 or $20 in a day.

When I ask them what stocks they do play I often hear a barrage of cheap 4 and 5 (penny stocks) letter ticker symbols that I haven ever heard of and all the good points associated with the company. "Mr. Haney just brought a new load of genuine imitation alligator skin chairs over to Sam Drucker's store, which should boost annual sales of Hooterville's only store. I think the stock is poised for an explosion to the upside."

There is a disconnect between what they would like to trade and what they actually trade because they can not afford Google but can afford the penny stocks, but this soon could disappear. As I write, GOOG stock is trading at $483.58 and the January 480 put is trading for $7.40. Under the old rule an investor who wanted to purchase even 100 shares of GOOG would have to put up $24, 179 in stock margin (100 shares X $483.58 stock price X 50% margin rate). He would also have to pay $740 for the one put contract to hedge the position.

The new rules would require the trader to post the difference between the stock price of $483.58 and the strike price 480, multiplied by the 100 shares. This $358 of risk combined with the $740 cost of the put will be a total capital outlay of $1,098, or about 1/44th the stock value. This is obviously much more leverage than the ½ stock margin. A trader wishing to increase his or her size can now trade almost $500,000 worth of GOOG stock ($483,580) for an investment and margin of $10,980. Now that is leverage.

How Will This Affect the Markets

According to William Brodsky, chairman and chief executive of the CBOE:
"The new margin rules will enable countless investors to employ trading strategies that previously were prohibitively expensive for all but professional traders."

But Wait, There's More

In some portfolios the margining rules will match the amount of money in a customer's account to the risk in the customer's portfolio in other ways. Portfolio risks in indexes is determined by calculating what the account's balance will look like after simulating for a 15% up and down move. A covered call, where one buys an underlying such as the SPYs and sells call options to receive money up front may no longer be margined at 50% even though the stock could conceivably fall to zero without the put for protection. Instead it would be margined at possibility as low as 15% movement, which would also be a dramatic improvement and allow as much as 75% greater leverage.

The New Rules Will Also:

The new rules will also likely increase volume dramatically in both the options and stock. What I have not found anyone touching on yet, but is almost certain to occur is, the artificial increase in demand for put options may force an even greater skew in put prices. Though this will create opportunities in other strategies it will still slightly force the cost of put insurance higher.

The new rules will also confuse and frustrate many traders. Many people reading this will be waiting by their laptops on April 2 to begin taking advantage of this new "toy," only to be frustrated when they are informed their broker doesn't know anything about it. Depending on the level of sophistication and determination by the broker, a couple may be ready to go one the 2nd of April, and most others will be handing out excuses in place.

Conclusion

What this really means for everyone is that there is now no excuse for not trading the strategies and stocks you like, as money and risk levels will both be lowered. What should be done between now and April 2, 2007 is to get up to speed on the strategies you intend to implement to take advantage of this rule.

Broken wing butterflies, gamma scalping, covered calls, collars, married puts and other strategies will be easier and cheaper to trade under the new margin rules. An increase in skew could benefit some of the strategies such as Broken Wing Butterflies while possibly being slightly more costly with married puts. No matter what you plan on trading, though, you should be attending retakes and reading all you can about the strategies until they become second nature. Get your friends and family involved, as many who were previously left out for financial considerations are now more likely to be qualified for trading these new strategies according to Mr. Brodsky. Get ready for a great 2007.


Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

[chinaman711]

Lou--I trade options and if i were you i would i would be real careful with options as many out of the money options end up worthless. A safer play is to sell options on a stock that you own and collect the premium but you better know that stock and hope it does not tank on you. As an example yesterday i sold some feb 5 calls on IMMU for .55 as im looking for immu to see 6 some day but i don't know when. I got in a few weeks ago at 3.10 to 3.22. Now if immu were to come out with some hot news and have a huge run then i would miss any gains over 5.55 but 5.55 would be a great s/t trade. The best thing that could happen is for immu to close at 5 when these options expire and then run to 6 as i will be selling the 7 1/2 options as iimu is a l/t play for me. If you can catch a stock that has a huge run over 2 years or so you can do well with these type of options. Good luck and be careful buying and selling calls.

[chinaman711]

By the way i would never buy a call or a put on a 4-5 dollar stock. If you trade puts and calls you need 20-100 dollar stocks to trade. BQI is another stock that i hold l/t and sell calls on and just hope it does not take off on me. Good luck

[aiki14]

Here's my advice for a newbie options player.
Have a few bucks you can afford to throw away.
Open your acct so you can at least track them in real time while you watch from the sidelines until you get a feel for how they move.
Read Stuff on the subject of options.
It's complicated so read it again. Learn the terms, know the difference between a spread and a straddle, covered and naked. Understanding what those things mean will ensure you have at least a basic knowledge of the topic.
Buy a call on a stock you feel will go up, pick a strike price and a expiration date and know why you chose both.
Repeat with put.

It is possible to make a fortune with these things, the ratio of those who do versus those who try is very small.
My success in these trades has been in Big oil, mainly CVX but XOM, MRO, VLO etc. I'll use protective positions against my stock positions or pure plays, I don't sell uncovered options, and I like to play straddles if the premiums are in my favor or I'll build them, especially going into earnings.
Straddles on big volatility is a good way to make a bunch against losing a few.

[OptionPundit]

Im trying to read as much as I can about trading options. I've never traded them. The question I have is, is the best or safest type of options trade one that you buy a option that the strike price is lower than the current equity price? Reason being is the lower strike price guards you in case the equity share price falls. any help or scenario's would be appreciated.

You may want to look at my site http://www.OptionPundit.net/

The site has a section called "toolbox/free stuff' and it has probably all that you will need to understand about the options. I suggest spending sometime, understand different components and in fact I also have a basic strategy simulator. I complied all this to a) use it as my command centre that i visit every day to find and explore opportunities, b) share the information that is freely available on the net and beginners pay thousand to get this (I was also one of those).

In fact I have also posted a note for my new year resolutions about trading. So enjoy browsing and drop me a note if any questions,

Cheers,
OptionPundit

[chinaman711]

IMMU hit support at 4.06, i bought back my calls at .15 for a nice little gain of .40. Hope to sell the feb 5's again at .50 to .60. but immu needs to hold 4 bucks. Good luck and keep an eye on XOMA at 2.60

[OptionPundit]

IMMU hit support at 4.06, i bought back my calls at .15 for a nice little gain of .40. Hope to sell the feb 5's again at .50 to .60. but immu needs to hold 4 bucks. Good luck and keep an eye on XOMA at 2.60

Congrats! Check out my posting on www.OptionPundit.net; what a great run was on ENR, PCP and BLK. 3 ut of 4 that I had posted y'day. Looking for Yahoo tonight,

Profitable trading,