Tuesday, 24 November 2015

Options Trading Explained

Newsletter 56

Basic Trading Concepts Defined

An option gives the buyer the right (but not the obligation) to buy the underlying asset at an agreed-upon price within an agreed-upon time frame. Options are a derivative, or secondary, market. Options can be based on stocks, indexes, ETFs, and more. That means that the ability to make profits in options depends upon a primary market. So in order to be successful at trading stock options, you need to have a solid understanding of how to determine when a stock is poised to move, which direction it is going to move, how much it will move, and how long.
Because stock option prices move with the underlying stock price, you are missing more than half of the equation by using this approach. You are studying the secondary market without considering the primary market. Instead, you have to know IF the stock is going to move, HOW MUCH it is expected to move, WHEN it will begin to move and HOW LONG it will take to move sufficiently enough to make your trade profitable.

How do you find this information?

You must start your options trading career not by learning options strategies but by first learning all you can about stock trading and, in particular, the trading style most suited for options. All option contracts have an expiration date. A popular time frame for options is 3 months. That places options clearly in the trading style called Position Trading.
In order to trade stock options successfully, you must know:
  • If the stock is going to continue up.
  • How many points the stock can move up based on the support and resistance in the stock chart.
  • How long it will take for the stock to move up to your target price based on the trendline pattern occurring in the chart and run analysis.
The answers to these questions are critically important to your success as an options trader. Before you ever look at an option chain or consider implied volatility and the Greeks, you need to consider whether you have chosen the right stock for your options strategy based on stock chart analysis.

To be successful at options, you must be able to read stock charts.

Study of the stock chart tells us that a bottom has completed and a buy signal with confirming indicators has formed to tell us that the stock is going to move up.
Resistance in the chart tells us how far, how many points, the stock can move before it begins correcting down, which is the price range where the exit should be anticipated. Support in the chart tells us how many points, or dollars, there are at risk.
The trendline pattern forming in the first daily chart as the price action develops tells us this stock tends to move sideways for roughly a month between runs up that gain around 3-4 points each. This makes an option expiration date of 3 months out reasonable. Then, only after you have studied the stock chart, you have the information you need to look at the option chains and find the right option to buy. You now know the Strike price and the Expiration date you need on the option contract.
Every time you trade an option, you must consider the actual price movement of the underlying stock. If you simply rely upon implied volatility or the Greeks for the option, you miss the most important aspect of your trade. This is just like deciding how much you want to pay without knowing what you're buying yet. No matter what option strategy you want to use, understanding the underlying stock-when it will move, how much it will move, and for how long it will move-is critical to your success. If you want to be an options trader, then give yourself the ultimate asset of learning how to read stock charts. This alone will save you from countless contracts that expire worthless.

Reference: Martha

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