Call option is a financial contract between two parties, the buyer and the seller of this type of option. It is the option to buy shares of a stock at a specified time in the future.

The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular stock from the seller of the option at a certain time (the expiration date) for a certain price (the strike price).

However, the seller (or “writer”) is obligated to sell the stock should the buyer decides to exercise his/her right on the option. The buyer pays a fee (called a premium) for this right.

Put option is a financial contract between two parties, the seller (writer) and the buyer of the option. The buyer acquires a short position with the right, but not the obligation, to sell the stock at an agreed-upon price (the strike price).  If the buyer exercises his right to sell the option, the seller is obliged to buy it at the strike price. In exchange for selling his/her stock to the buyer, the buyer pays the writer a fee (the option premium).

Strike price, also referred to as exercise price is the price at which the owner of an option can purchase, in the case of a call, or sell, in the case of a put, the underlying stock. It’s the price at which the stock will be bought or sold when the option is exercised.

Premium is the price that buyer pays the seller for carrying the risk for the obligation.  This is similar to insurance premium where you pay the insurance company a premium, so in case if anything happens, the insurance company is obligated to compensate the damage.  The price of the premium depends on many different factors such as strike price, time left until expiration date, interest rate, volatility, etc.

Expiration Date – Options is a wasting asset, meaning that it loses value as time goes by.  Once the option expires, the option no longer has any value and become worthless.  The expiration date is found in each option contract when it is bought.

American Style and European Style Option – There are two different types of options.  American style option is one where buyers can choose to exercise the option any time up until the expiration date whereas the European style option is where buyers can only exercise on the expiration date.

These are just some of the most common terms you will come across when starting out in option trading.  If you are serious about learning how to trade options, then you should adhere to some of the common option trading tips that every option trader would abide by..

I thought I’d provide an example of a Bull Call Spread (BCS) using the Commonwealth Bank as an example. There is a lot of volatility in the market at the moment. If you have studied my course then you will know that high volatility is a great advantage for the Option Seller – a decrease in implied volatility means a decrease in the Option premium – but let’s get back to this example!

Since making a high around $62.00 in November 2007 CBA has spent the last few months falling to its current price of $47.00. Can it go lower? Is this the bottom? I have no idea! Instead of buying the stock and watching it plummet even lower let’s look at a strategy where we know EXACTLY what our MAXIMUM risk and MAXIMIM profit is – a Bull Call Spread.

When you BUY a CALL Option your view is that the underlying Stock will rise. So with CBA closing last night (14th Feb) at $47.05 you might to decide to BUY a CALL Option with a Strike price of $48.00 that expires on the 27th March 2008. The quoted price for this option is $1.69. If you bought 2 contracts it would cost you 2,000 @ $1.69 = $3,380 (plus brokerage). In 10 days time if the stock price increased by 4% to $48.93 the Option price would be somewhere around $2.15. You could then Sell the CALL Option and profit $920 or around 27%.

To reduce the cost of Buying the CALL Option you can SELL a CALL Option at a higher strike price. Building on the above example you would SELL 2 March CALL Options at a strike price of $51.00 and receive a premium of $0.71 which means you receive 2,000 @ $0.71 = $1,420. So your total cost would be the price that you paid for the contracts that you bought ($3,380) less the money that you received for the Options you sold ($1,420). Total Cost $1,960.

The advantage is that you are reducing the cost of entering the trade. The disadvantage is that you are limiting your profit to the upside if CBA trades above $51.00. I like the Bull Call Spread trade because you know your maximum profit and maximum loss before you enter the trade. The best way to view this is via a picture (listed on the next page).

Please note that this trade is purely for educational purposes only. I’ll send an update of this trade in a week or two to see how it would be progressing. If you have any questions you are more than welcome to send me an email glenn@optiontrader.com.au.

Cheers

Glenn Dove

www.optiontrader.com.au

Update written on 22nd February 2008

It’s always worth reviewing your trades especially when you trade Options. One week ago I provided an example of a Bull Call Spread Option strategy on CBA shares. At the time of the Option trade CBA was trading @ $47.05 and we had entered a long position.

How would we be going on the 22nd February with the price of CBA trading at $42.40?

The trade has not gone in the direction that we wanted but there’s a lot we can learn from this type of strategy. The Bull Call Spread (BCS) that we entered entitled us to Buy 2,000 CBA shares @ 48.00 and to sell 2,000 CBA shares at a maximum price of $51.00 anytime before 27th March. The total cost of the BCS position was $1,960.

So what’s so good about that?

• We are in control of $96,000 of CBA shares (2,000 @ $48.00) and it only cost us $1,960 to enter the trade. This works out to around 2% of the total trade value.

• We are limited to a maximum loss of the premium that we paid $1,960. If we had of bought 2,000 CBA shares at the market price (on 15/2) we would have paid $94,100. With the current price of CBA at $42.40 we would be sitting on a paper loss of $9,300.

So as you can see even though the trade has not gone in the direction that we wanted the BCS has provided great leverage while limiting our loss potential to only 2% of the trade value. Also remember that we still have until 27th March for this trade to work. You could also decide to close the position if you thought that the CBA had no chance of getting back above $49.00 by the 27th March which would leave you with a loss of $1,297.

It’s also worth mentioning some of the disadvantages even though I believe the advantages far outweigh the disadvantages:

• If there are any dividends payable during the Option period we are not entitled to them (as we don’t really own any shares)

• We have a limited time (until the Option expiry date) for the trade to become profitable. Once the contracts expire they become worthless.

• Our profit potential is limited due to the fact that we SOLD Option contracts to reduce the cost of the Options that we bought.

If you have any questions send me an email: glenn@optiontrader.com.au

Cheers

Glenn Dove

www.optiontrader.com.au

In the book “The New Market Wizards” written by Jack Schwager, concludes that nobody can win without an edge, even you have the world greatest discipline and money management skill. If you trade futures on the All Ordinaries Share Price Index (SPI), you have to know exactly what is your trading edge; particularly, if you are a professional floor trader. With the trading edge, you should able to see the buy and sell orders that coming into the trading pit and also who is buyer and seller. Besides, the speed of execution of your orders and the transaction costs also should able to see. The popularity of the stocks, options and futures is increasing; therefore, many people trade these products. Only a small proportion of these traders apply a real trading edge. The main reasons for the unsuccessful of many private traders in the financial markets are due to the lack of a trading edge, poor risk management and insufficient capital. The key point here is to find an edge, utilize it consistently and use the right risk and money management techniques. When the odds are in your favor, it is better that you learn how to trade options. It is also importantly when the odds are not in your favor, make sure you stand aside. You are doing yourself with the best possible chance of success if you doing so. Trading systems are as many as traders. We won’t trade a system if it doesn’t provide us with some sort of edge. If you have a system, which is able to give you an edge, why not further enhance your edge by trading options in a right circumstance. Before placing a trade, try to get as many factors that going in your favor as possible. By practicing this, you provide yourself with a much greater chance to success in the long run.

Without doubt, with any form of trading, there are no absolute guarantees. You can’t help compared to the many of the people who do not know anything about options and trade without an edge. But, you have a better chance to succeed in the long run and reach your financial ambitions. Flexibilities that can be offered by options are as follows:

i) Profit gained from an accurately anticipating rising or falling market. ii) With a relatively small disbursement, your potential returns can be greatly magnified.

iii) If the market goes to the way that you anticipate, you have unlimited profit potential, whilst you limit your risk by choosing an amount that you afford to risk.

iv) Profit still can be gained by correctly picking options where the market will not go.

v) Profit gained from flat or non-trending phases markets.

vi) Profit gained by letting the time passes by.

vii) Profit gained at an increasing rate when the market moves further in your favor.

Extremely flexible trading tool is option. You can use options trading strategies that are precisely suit your view of market, whilst sewing them closely to your personal risk tolerance level.

People who trade options for a living and as their business will try to understand and apply the principles, which have been outlined in this article. They do so because they know that there is an edge for then to be gained compare to the people who don’t. They are similar to the typical casino gambler if they do not trade with edge; their money will be destined to be lost ultimately. They are exactly like the casino itself if they trade with trading edge. For those people who trade the markets to make their living, you probably don’t have the chance to talk with them. Their occupation looks exotic and these people are imagined as weird mathematical geniuses who could give their money to Kasparov to run it in a chess tournament. The flair of occupational options traders couldn’t be going beyond from the veracity. Although many of the professional options traders who involve in the financial markets are intelligent people, they were not in the genius category. Nevertheless, they have one thing in common among them. They knew and applied certain unique principles in their options trading. The principles that they utilized offered then an edge to successfully trading in the market. Therefore, throughout their options trading life, they earn a good living.

You don’t have to be a professional options trader. The edge offered from the principles to the professional options traders also available to the private traders as well. Practically, these principles can be learnt and applied by yourself and the odds can be helped to put it more squarely in your favor. All the advantages that most of the professional options traders have may not be possessed by you. By using the same principles that they used, you can learn to make your trading more selective. In this way, you too can benefit from a trading edge.

Often times, people have just enough information to be dangerous…to themselves and their financial future. When they don’t find success, they find themselves paying the same high price for an alternative service or seminar. In order for people to have a full understanding of the options market, they need to speak with a professional who knows how they think and operate.

This is the one thing missing from many options seminars today. The course material is not always drawn up by a professional, but rather someone who has text book answers to standard market material and is in the business of making money. This can make it very difficult for the novice investor or trader who is looking to get their money’s worth out of the seminar. Options trading is not something that can be learned in 5-7 days. People who believe it can are either trying to sell you something, or do not have enough experience to advise you on how to trade options.

Do yourself a favor and seek out as many opinions as possible when choosing an options trading platform. There are many small differences outside of commissions that the less educated will not be aware of. One example is charting options. Most retail investors lack the most needed skill when it comes to getting the best entry prices on options, a chart. Would you buy a stock without looking at the chart? Probably not! This is the type of information you need to be educated on to find success in options trading.

To learn more about options trading go to http://www.stockmarketfunding.com

Selling covered calls is sometimes compared to taking out a limited insurance policy on your stocks, except that you get paid to take out this policy.

How? If you own a stock with options available, you can sell an option to call, (buy), your shares away from you at a given price, known as the strike price.

You’ll receive money, called a premium, for selling a call option. In fact, you’ll often receive a bigger $ amount per share by selling a call premium than you’re currently receiving as a dividend. This money reduces your net cost basis on the stock, hence the insurance analogy.

What’s the catch? By selling the call option, you’re obligating yourself to deliver x amount of shares of the underlying stock at a specific price – the strike price.

Each option contract corresponds to 100 shares of the underlying stock, so make sure that you own at least 100 shares of the stock BEFORE you try to sell calls against it.

Here are a few basic option terms that will help explain this option strategy:

Strike Price: The price attached to a given option contract, that a call seller is obligated to sell the underlying stock at to the buyer.

Call Bid Premium: The amount of $/share that call buyers are currently offering, (Bidding), for a given call option.

Expiration Date: The date that an option expires, which is normally on the 3rd Friday of the option’s contract month.

Option Chain: The listing of options available for a stock. These are arranged by calendar month. Normally, the months available revolve throughout the year: the front (current) month, the next month, one month per quarter, and the following January. Some more heavily traded stocks have more months available simultaneously.

What triggers the sale of your shares when you sell covered calls? If the price of the underlying stock rises to or past the combination of the strike price and the call premium you were paid, your shares will usually be “assigned”, (sold).

If you sold a $15 January call option and received $1.25, your shares would be assigned if the stock rose to or above $16.25.

Assignment normally happens at or near the expiration date.

Assigned Yield: The % yield a call seller receives when his shares assigned, calculated as follows: The difference between his basis cost on the underlying shares and the call’s strike price he sold at, dividend by his cost basis.

For example, if you sold that $15 call, and your cost basis on the stock was $14.00, you’d earn an additional $1.00/share, if your shares were assigned, which would equal an assigned yield of 7.14%. ($1.00 dividend by cost of $14.00).

Call Yield: The yield that the call seller receives for the call, calculated as follows: The call premium divided by the cost basis/share of the underlying shares.

In the above example, the call seller sold a call for $1.25, and the cost basis of the stock was $14.00. Therefore, his Static Yield equals 8.93%, ($1.25 divided by $14.00)

Most covered call sellers compare the amount of dividends they’d receive prior to the call’s expiration, to the amount of call premium they’d receive, to judge if it’s worth selling the call option or not.

Total Assigned Yield: The total of the dividends received, call premium received, and assigned yield received, all dividend by your cost basis of the stock.

In this example, if you’d received $.60/share in dividends during the investment term, plus $1.25 in call premium, plus $1.00 assigned yield differential, you’re total income on the trade would be $2.85, on a $14.00 stock. This equals a 20.36% Total Assigned Yield.

Total Static Yield: This is the combination of the dividends received or qualified for prior to expiration, plus the call premium received.

A Static Yield occurs when the stock DOESN’T rise to a price that is equal to or over the combination of the strike price and call premium, and the call seller’s shares are not sold.

To sum up, you can add up to 2 new income streams to your dividend income on any optionable stock, by selling covered calls against it.

We took a stock with a $.60 dividend, (a 4.3% dividend yield), and earned over twice as much $ in call premiums immediately, $1.25, (8.93% call yield), plus, we positioned ourselves for an additional $1.00/share if assigned, (7.14% assigned yield).

My pal was a normally a mild-mannered sort – very reflective, always weighing the consequences rationally before acting. In short, a logical thinker.

Imagine my dismay when that one phrase, “trading options”, triggered this unprecedented tirade. You’d think I’d insulted his family or something even worse.

After a few seconds had passed, I realized the reason for my friend’s outburst. He, like so many other investors, had only lost money trading options.

Why? Because he’d never discovered the number one option trading secret: 3 out of 4 options expire worthless. You read that correctly, when you trade options as a buyer, you have a 25% chance of making money, and a 75% chance of losing money.

This is why professional traders and investors favor the option strategy of selling options, rather than buying them, in hopes that the trade will go their way.

“Wait a minute. How can all of those options just expire worthless? I’ve seen ads for 100’s of option strategies and trading systems on the internet. They can’t all be losing money.”

I had to smirk. Now I really had him thinking. He knew that I hadn’t yet told him the big “secret behind the secret”, but he couldn’t quite put his finger on it.

“I have one word for you, my doubting friend”, I said,…”Time”. “When you become an option seller, you have time working FOR you, instead of against you. The reason is simple – as puts and calls get closer and closer to their expiration date, they lose their time value, due to “time decay”, or theta, the Greek letter that option traders use to denote the % of change in time value of an option.”

This is true of any option, no matter if you’re buying or selling call options or put options, or using a covered call strategy. It’s one of the big secrets of options investing that doesn’t get written about too often.

Because of the power of time decay, you can actually guess wrong about the direction of the market, or a stock, and you’ll still make money selling a call option or put option, as opposed to the buyers on the other side of the trade, who not only have to guess the stock’s future price movement correctly, but must do it BEFORE the option expiration date.

This helps to explain why even conservative investors use the covered call strategy, which is widely considered one of the most conservative option trading strategies around.

To sell covered calls, you must own at least 100 shares of the underlying equity, since each call contract corresponds to 100 shares of the underlying stock.

This is a tool you can use to hedge your portfolio, and lower your risk, by receiving “call premium” money, which lowers your break-even cost basis.

Selling covered calls is a short-to-mid-term option strategy you can use to double and triple your yields on new stock purchases, and/or to earn more income from your existing portfolio.

A very simple example of an options trade would be this: If you’re selling a commodity worth $100,000 (say 1,000 shares of a stock worth $100 per share), and a prospective buyer likes the price, they can offer to pay for an option to buy all of those commodities, while spending the time researching other investments. Say, for example, they’re offering you $1,000 to hold that price for them while they gather the rest of the funds, which they say will take three months.

When three months passes, they either pay the remaining $99,000 for the shares of the stock, or forfeit the option. If the stock goes up in price to $110 per share from $100, they can either buy the stock, or sell the option to someone else for the difference between the old price and the new price. Either way, the person holding the option stands to make a tidy profit.

Options trading has its own set of terminology, which we’ll get into a bit later, but the basic premise is this: You buy an option to purchase a stock or commodity at a given price; the option expires after a given time period (American style options trading), or the option must be exercised on a specific date (European style options trading).

There are two principle types of options that are traded. Calls increase in value as the stock price rises, and puts increase in value as the stock price declines. (There’s a lot of fiscal mathematics behind both of these, but the layman’s explanation will suffice.) In most cases, options are sold to other investors just before they expire; most options traders don’t end up holding shares in the stock they have options for; the options are bought, sold, liquidated and transacted before their expiration dates. It is possible to have both call and put options on the same commodity or stock; this is a “straddle” strategy.

Options trading is not a casual investment strategy; it’s a strategy used by people who are investing as their profession, or who intend to manage their own wealth directly. The benefits of options trading is flexibility, coupled with (in the case of put options) a bit of a countercyclical strategy for bear markets.

The key to options trading is market research on specific stocks; an options trader will be researching stocks that are either slated for a price spike (call options) or are likely to undergo a price decline (put options). How quickly these options express themselves is a measure of market volatility, and most options traders will try to take a neutral position – they’ll put in put and call options to cover both directions, and to cover themselves against broad market trends.

Options arbitrage is a lower risk strategy done by floor traders, and can be short term profitable, with good liquidity. The aim is to swap options with other traders before certain factors influence the market, or to get rid of underperforming options while still getting some profit out of them. Options arbitrage is perhaps the best place to start in options trading for a novice.