Options

Options are a trading tool that leverage an investment, and limit the loss. The disadvantage of buying an option is the premium that one has to pay; therefore, the gain is a smaller percentage than the move that the underlying instrument makes. Premiums erode with time and eat away the profit.

On the other hand, the most attractive part of options are the leverage, and the fact that the losses can be limited if there is a major adverse price move. Even though the premium erodes the profits, due to the high leverage one can earn more money using options on stocks and ETF's than the underlying instrument. Key to success in options trading is timing. If the timing is not right then the option's value will erode with time. Swing trading is one of the best ways to take advantage of option trading. With swing trading you are in and out within few days; therfore, there is not much time for the option to erode.

An option is a contract giving the buyer the right to buy an underlying asset such as stock or index tracking instruments such as DIA or Spider (ETFs) at a specific price on, or before a certain date. An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.

As an example assume you want to buy a house, but you are not sure which way the housing market will go. Today is March 20 and you approach the seller of the house and offer to buy the house six months in the future (in September) for $300,000 with no obligation to buy it when September arrives. The seller agrees but charges $6,000 premium for the option to buy the house.  

If the price of the house appreciates to $320,000, you will buy the house for the $300,000 the seller agreed to. Your cost will be $300,000 plus the $6,000 premium paid for the option – a net profit of $14,000. However, if the value of the house declines to $280,000 then you would not pay the agreed price of $300,000, and forgo the $6,000 premium.

Buying an option contract to buy a stock at a specified price on a future date works the same as the above example.

You think that the Dow is going to go up so you want to buy DIA [Diamonds], but you are not sure – what if the share value goes down? Instead of buying the stock, you decide to buy a contract that gives you the option to buy the underlying stock (DIA) at a future date at a specified price. If the price of DIA goes up then you could exercise your option to buy the DIA since it would be in a profit already.

The price paid for an ‘option’ is called premium. Here is how premium works. DIA is trading at $110.00 and you buy an ‘option’ to buy the DIA in the future for $110.00 per share. The person who sells you the ‘option’ charges $1.10 per share (this is the premium you pay for the privilege of deciding if you want to own shares of DIA in the future for $110.00 per share). If DIA goes up to $113.00, at the expiration date of option, then you would have theoretical profit of $3, because you have an option to buy DIA at $110.00 and DIA is trading at $113.00. Your net profit would be $3 gain from the rising price of DIA minus $1.10 premium paid for the option. The net profit is $1.90 ($3 - $1.10).

Most people do not exercise their right to buy the option, but sell the option at a profit. If DIA goes up in value to $113.00 from $110.00, the value of the option would appreciate from $1.10 to $3, at the time of the expiration date, and you would simply sell the option at $3. The net profit is still $1.90 ($3 - $1.10), so unless you want to own the stock there is no need to exercise your option.

Premiums have time value. Assume that the $1.10 DIA option contract is going to expire six weeks from today. The time value of the option for each week will be about $.18 ($1.10 divided by 6 weeks).

Going back to the above example of the $110.00 DIA option that was bought for $1.10. If DIA goes up from $110.00 to $113.00 in value in one week instead of in six weeks the option value would appreciate by $3, plus there will be remaining time value of the option of $.92 ($1.10 - .18 one week time value loss). The value of the option would be $3.92 ($3 price rally plus $.92 value of the option premium).  The time value is the reason why most options are not exercised, but are sold at a profit if the underlying stock has rallied.

The object of buying an option is not to hold till the expiration date, nor to exercise the option to buy the underlying stock. The object is to profit from premium appreciation do to the underlying stock’s increase in value.

Three major factors will influence the price of the option.

An option contract with the right to buy [go long] the underlying asset is a ‘call option’. An option contract with the right to sell [go short] is a ‘put option’.

Leverage

One contract of option conveys the right to buy or sell 100 shares of the underlying stock. If one contract of ‘call option’ is purchased then the value of the option is equal to the share price of the stock times 100 shares.

In the above DIA example, the strike price of the option was $110.00, so it was worth $11,000 ($110.00 x 100 shares). Instead of paying $11,000 to buy 100 shares of DIA, one contract of ‘call option’ for $110.00 total premium can be purchased ($1.10 premium per share x 100 shares).

If 100 shares of DIA go from $110.00 to $113.00 in one week, there is a profit of $300 for an investment of $11,000 - a 2.7% profit. On the other hand, if one ‘call option’ is purchased for $110.00 ($1.10 premium x 100 shares), and the option’s premium value goes up to $392 then there is a $282 profit on an investment of $110 - a 256% profit. Options provide a substantial leverage. However, if the timing of purchasing the option is not good the premium will erode. In other words, to profit from options one must have good timing.

The above example is an ideal scenario, and ideal scenarios do not happen often. A $3 rise in DIA [or 300 point rise in Dow] in one week does not happen that often. If the timing is not right, the Dow can go against ones position and then may take weeks to recover. Each passing week would eat up more of the premium.

Going back to the original option example above, if it takes six weeks for DIA to go up $3 then there would be a profit of $1.90 ($3 profit - $1.10 premium). That would yield a return of $190 profit on an investment of $110 – a 172% profit. Even if it takes six weeks to achieve $3 rally in DIA [300 points in Dow] the build in leverage in options will still provide a substantial profit.

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Using Options with Dow Indicator

When it comes to trading options timing is the most important aspect for earning a profit. Dow Indicator is an excellent timing tool that often picks the turning points within a day or two.

DIA and SPY options give the most flexibility for trade execution do to their small contract size. Futures traders will have to use the E-mini SP 500 options, because the E-mini Dow options are not liquid enough to trade with efficiency.

We have found that the DIA options to be slightly less expensive than the SPY options.


Strike Price

In general it is more profitable to trade out of the money options that are two or more strike prices out. Pay attention to the asking prices for various strike prices. They could be over inflated, and buying the less inflated options will give a bigger return.

The value of an option depends on number of days left to expiration and volatility. The best opportunity is when the number of days to expiration is one to two weeks and the volatility has shrunk for a day or two. At that time the options are inexpensive and when the price moves in the directions desired the value of the options will appreciate substantially.

If the timing is good then options can provide substantial leverage and yield big returns.

To learn more about options you could visit the below links

http://cboe.com/LearnCenter/OptionsInstitute1.aspx

http://cboe.com/LearnCenter/Glossary.aspx