optionMONSTER: Education - Table of Contents

E D U C A T I O N

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Options Basics
Trading stocks is reasonably easy, at least in theory. If you think a stock is going up, buy it. If you think it is going down, sell it; or sell it short if you are a real risk-taker. If you think a stock is going nowhere, sell it or avoid it in the first place. The stock price is what it is and that is what you pay. Things are not so simple with options trading. Many factors influence the value of an option contract. It is for largely that reason that most retail options traders underestimate the challenge of making money with options.
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Butterflies and Condors
Butterflies and Condors are trades intended to take advantage of a neutral outlook and/or high implied volatility. They involve buying two options, at a net debit, to establish a position which profits if the underlying stays within a given range.
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Calendar Spreads
Anyone who has traded options for a while has a feel for how time decay can eat away at an option's value, especially as expiration gets closer. Options positions can in fact profit from time decay, but this entails selling options and can involve significant risk. Long calendar spreads provide a limited-risk way to take advantage of time decay inherent in different expiration dates.
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Covered Calls
You own a stock that is part of your long-term investment portfolio. You like it long term, but don't see it going anywhere over the short term and would consider selling it, given the right terms. You would also like to generate some income, but you aren't interested in selling your stock only to buy a CD with a next-to-nothing return. Given these conditions, many self-directed (or "retail") traders use covered calls to generate income in their accounts. It is highly conservative and therefore widely popular. In fact, many stock traders begin trading options this way.
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Long Calls
You think XYZ stock is going to go up in the near future. You don't really want to tie up all the capital necessary to profit, and you don't want to pay margin rates. But you still want leverage. As one top hedge fund manager said, "the only way most people really do well in the markets is to be long and leveraged". Buying calls is the best way to be "long and leveraged".
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Option Greeks
Option prices can change due to directional price shifts in the underlying asset, changes in the implied volatility, time decay, and even changes in interest rates. Understanding and quantifying an option's sensitivity to these various factors is not only helpful -- it can be the difference between boom and bust. The option "greeks" come from the pricing model (normally the Black-Scholes model) that gives us implied volatility and quantifies these factors. Delta, theta, and vega are the greeks that most option buyers are most concerned with.
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Options Pricing
So you bought a call option prior to earnings, with the expectation that the stock price would go up. And go up it did! But your call option didn't gain in value. Now, as you hold onto it and ponder what could have happened, you start losing money. What is going on? What you are seeing is the result of the various factors - other than the price of the underlying - that help determine an options price. Foremost are implied volatility and time decay.
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Protective Puts
Insurance for your portfolio - or any stock position - is available using put options. While options have the reputation of being risky assets in some circles, their original purpose was as insurance policies to protect positions, and buying puts is a limited risk way of doing just that.
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Short Puts
Many retail traders use short puts to generate income in their accounts. Short puts can also be an excellent way to acquire stock. This is a widely used strategy and is considered one of the most conservative options strategies. The position is very similar to a covered call.
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Straddles and Strangles
There are times when you just know that a big move in a stock is coming - the problem is that you don't know which direction. Wouldn't it be nice to have a strategy that could profit from such moves regardless if they were up or down? Long "straddles" and "strangles" fit the bill.
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Vertical Spreads
One of the issues with buying "naked" calls and puts is that by the time you purchase them, the premiums are already very high. As options trading is a probability game, the higher the premiums are, the lower the probability of profit for buyers. So to lower your exposure to those high premiums, you should know when to spread 'em.