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What Are Stock Options?

Stock options are merely contracts to purchase or sell 100 shares of stock in the future. Since stock options aren’t actually units of ownership, like shares of stock, and their value relies on the price and trend of stocks, stock options are additionally referred to as “derivatives”.

Options Types- Calls and Puts

A call option is a contract to buy 100 shares, and a put option is a contract to sell 100 shares. In general, the one who is selling the put or call is willing to sell it because he collects a premium in return for risking his 100 shares. Both put and call options are offered with various expiration dates up to three years in advance. The more time remaining until the option expires, the more premium the call writer can charge. The most important thing to remember about options is that they, unlike the underlying stock, expire after a certain amount of time (option contracts can last from a week to three years).

The buyer is willing to pay the premium for the right to own the shares in the future because he or she is purchasing time-limited leverage. Leverage in the sense that you your returns can be great if the stock moves significantly up or down, but time-limited in the sense that the options can expire and be worthless if the stock price does not move up or down as the buyer anticipates.

Selecting the Right Stock Option: What you need to Consider

There are a number of things to consider when you place an option trade:

Option Month – What month should your option expire?

Avoid using front month options, the next month to expire, except for insurance or selling naked or bull put spreads, etc.

Select an expiration month at least one full month out for a 1 – 2 day trade

Select an expiration month four months or more out for a trade over 2 days

Select an expiration month over 9 months (LEAPS) for a trade over two weeks

Strike Price – What is the best choice?

The best way to select the right strike price is to use the delta and time value rules that follow. It should force you to automatically select the right strike price. However, if there is a conflict then do better than the rules. Example: You end up selecting the option to buy with the worst time value – so then go to a strike price that has a better delta than the minimum requirement or to the next month out to get the better option that does not fail any of the rules.

Here is a basic rule of thumb to get you close to the right option to consider for a short-term trade with a delta close to .70: Short term trade in the money usually takes about $5 in the money. Expensive stocks take about $10 in the money High Volatility stocks could be as much as $20 in the money (EXPENSIVE)

Delta – What Delta should you consider?

1 – 2 days in the trade Delta .70+

Over 2 days in the trade Delta .40+

Over 2 weeks in the trade Delta .25+

Time Value & Cash Value Considerations

Make sure if you are buying an option not to buy the option with the highest time value in it. (Time value = Premium – In the Money)

If you are selling to open a trade (selling a naked put or writing a covered call) then selling to open an option with the highest time value is GREAT!

Bid & Ask – How much should the spread be?

Minimum option spreads are 5 cents on options under $3 and 10 cents on options over $3 (these are my favorite when I can get spreads this small)

Maximum for short term trades is 25 cents or less

If you must trade a stock with a large spread, be in that trade for more than a few days and get in on a serious low or high to play the downside so you can recover from this spread. Remember you don’t make your first penny of profit until you can cover your spread between the bid and ask!

Don’t forget to try to get a deal in the spread if possible to reduce the bid x ask spread up front costs you have to cover to make that first penny.

Open Interest – Is open interest important? What is the requirement?

Minimum requirement is 100 contracts or don’t do the deal! Anytime you can get open interest in the thousands it is even BETTER! It makes your entrance and exit easier and the bid x ask spread tend to be much smaller.

Money Management

How much in one trade: If you are trading with small funds, try to be diversified by trading an exchange traded fund like the QQQQ since you have to put a large amount of your funds in one trade. This will at least help you to be diversified in 100 stocks at one time. Once your funds have grown, I like to not put more than 5 – 10% in any one trade. Also don’t have all your trades in the same sector.

When do you have enough to retire? You want to have set aside two years of living expenses in addition to your trading funds before you retire.

Diversification: Don’t have all your investments in the stock market. Real Estate is a nice compliment, as well as residual earnings from perhaps writing a book.

Graceful Exits – If the trade does not go the way you hoped.

The most important thing that you can learn to become a successful trader is how to pull the plug when the trade goes wrong! If you cannot get good at this then you should NOT be trading!

As a general rule of thumb on stock don’t let it go more than 8% against you and on options no more than 20% against you to run for the door fast. There is nothing worse than having no funds left to live to trade another day.

Once you discover the power of pulling the plug fast when a trade goes wrong, and you see how much better the trade goes when you finally can enter it at the right place, you will wonder why you ever felt the need to stay in a bad trade! You can really make some sweet money pulling the plug and fixing a bad trade!

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