Types of Stock Options and Trading System
Before I get into details for a simple Stock Options Trading System, lets define some basic options terminology.
Now there are two types of stock options:
1. Call Option
2. Put Option
You would buy a Call Option when you think the price of the underlying stock is going to go up.
Call options increase in value when the underlying stock it's attached to goes up in price, and decrease in value when the stock goes down in price.
So buying Call options gives the buyer the right, but not the obligation, to buy shares of a stock at a specified price on or before a given date.
You would buy a Put Option when you think the price of the underlying stock is going to go down.
Put options increase in value when the underlying stock it's attached to goes down in price, and decrease in value when the stock goes down up price.
Some important stock options definitions:
- Strike Price: is the fixed 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 when the option is exercised.
The strike price is often called the Exercise price.
- Expiration Date: is the date before which the option can be exercised. There are different dates to choose from.
- Intrinsic Value: is the difference between the Stock price and the Strike price.
Stock Price = $65.00
Strike Price = $60.00
Intrinsic Value = $5.00
In other words, it is the amount by which an option is "in the money".
- Time Premium or Value: is the amount of money you pay for the length of time until the option expires. It is the difference between the actual price of the option and the Intrinsic Value.
Option Price = $7.00
Intrinsic Value = $5.00
Time Premium = $2.00
The more time you have left until expiry, the higher the time premium and visa versa. And therefore, as you get closer to the expiration date, the value of the option decreases more and more rapidly, until it is at zero on the strike date.
When you BUY Call and Put options, Time Value is your ENEMY!!
- At the Money: is when the stock price and the strike exercise price are the same. There is no Intrinsic value.
- In the Money: is when the stock price is above the strike exercise price. There is Intrinsic value.
- Out of Money: is when the stock price is below the strike exercise price. There no Intrinsic value.
Phew! Had enough?...but wait there is more.
The Option Greeks
The following are know as Option Greeks and are measuring tools. They are individual measurements of option risk sensitivities, and they have a direct affect on Option prices.
The Greeks that you use depends entirely on the type of trading or stock system that you use.
- DELTA: this measures the rate at which the price of the option changes with changes in the underlying stock, realtive to speed.
ie. If the DELTA of a call option is +.75, then as the stock moves up $1.00, the option price will increase by approximately $0.75.
If the DELTA of a put option is -.50, than as the stock moves down $1.00, the option price will increase by approximately $0.50.
Why is this important? When choosing options, you want to find those with a reasonably high delta, so that as the stock moves, the option price will move close to a 1:1 ratio as possible.
If you trade Deep ITM (In The Money) options, you maximize the leverage of DELTA.
The stock options system that follows utilizes Delta.
- GAMMA: this measures that rate at which DELTA changes.
GAMMA helps a trader measure risk, because a high Gamma means that an option's Delta is very sensitive to change. Gamma is always high when an option is ATM or NTM (near-the-money), and it is low for Deep ITM or Deep OTM (Deep-Out-of-the-Money) options.
GAMMA is really only useful for those who trade something called Delta Neutral options - if Gamma is high, it means that the stability of your trade could change any time, and so you need to monitor your position closely.
The stock options system doesn't factor in Gamma.
- THETA:This measures the rate at which the price of the option changes over time.
For example: If the THETA of an option is -0.80, then your option value will decrease by approximately $0.80 every day until the contract expires.
NOTE: The closer you are to expiration, the more the THETA grows therefore the price of the option decreases at an increasing rate over time.
Why is this important? If you BUY calls or puts, THETA or TIME DECAY becomes your enemy. If THETA is high, you must plan to not hold on to the option for too long!
TIME DECAY will eat up the profits made from an increase in the stock price.
- VEGA and ZETA: These two indicators measure the change in an options value relative to changes in Volatility.
VEGA measure the effect of changes in Historical Volatility, and ZETA measure the effect of changes in Implied Volatility.
In both cases, higher volatility means higher options premiums, and therefore potentially more profit; it also means more risk!
OK, all done, I promise!
Your Stock Options Trading System
So now the system.
It's called the Pitbull Stock Option Mechanic.
First and the most important step is choosing the appropriate stock to buy our option on.
If the stock itself doesn't go the way we anticipate, the option won't either.
We will use the Pitbull Breakout Method to select the appropriate stock. This gives you the best opportunity to pick stocks that have the highest probability of successfully appreciating in the months ahead.
Now which option to buy.
As stated in the stock options terminology above, Delta is important, as the higher the delta, the closer the option price moves up relative to the stock price.
Also, as stated above, Time Value is our enemy. The closer we get to the Option Expiration date we pick, even though the stock price may increase, our option price actually starts to shrink, negating our possible profits.
So which type of option to buy?
To boil it down to one sentence the answer is....
You buy an option 3-6 months expiration date out; buy a strike price $5 to $10 in-the-money (called Deep In-the-money), and NEVER, EVER hold it closer than 30 days to expiration.
It's that's simple!
Huh?...you are probably thinking.
The Pitbull Stock-Option Mechanic manual gives you more detail and insight and I strongly advise you purchase it (very reasonably priced), but that's the premise of the system.
Of course, you still need to practice the appropriate money management principals AND pick the right stock (which we use the Pitbull Breakout system for), but trading options can really be that simple.
And simple is always best...right?
For more in-depth Stock Option Trading strategies, I recommend you read “McMillan On Options” written by professional expert Options Trader Larry McMillan.
Not only will you learn all the basics of trading options, you will also gain a unique insight into Larry McMillan's personal philosophy on options, and discover the innovative new tactics and strategies he applies to his own trading and analysis.
You will learn advanced concepts for those of you who have been in options directionally but want more... more control of risk, more profitability, more control over time.
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