Traders Toolbox: Learning Options Part 2 of 4

Many people like options because they believe them to be less risky than futures. Options sometimes offer reduced risk, but usually at the cost of reduced profit potential.

One drawback of options is that a trader must consider market speed (volatility) as well as direction. Traders who buy or sell options outright to profit from up or down moves in the underlying market can find themselves fighting an uphill battle against volatility and time decay. With futures, if you're right about market direction, you'll win. With options, you can be right about the market and still lose.

If a market is trading at 200 and you buy a 210 call expecting a rally, you'll still lose on the trade if the market only rallies to 205 by expiration; your 210 call will be worthless. The same thing would happen even if the market rises as high as 220, but does so one week after expiration. In each case you would be right about market direction but would not profit.

The advantage of options is their flexibility. Because of the variety of strike prices and expiration dates a trader can choose, options naturally lend themselves to spreading strategies (simultaneously buying an selling different options), accommodating varying views of market direction and risk levels. Traders can design option strategies that will profit if the underlying market goes up or down, moves in either direction by a certain degree or remains unchanged.

Options also allow you to profit without predicting market direction because of time decay and fluctuation in volatility that increase and decrease premium. For example, a trader might sell as out-of-the-money call on a relatively volatile futures contract he thinks will fall. Over then next two months, however, the market does not fall, but gradually moves higher, trading in a narrow range (but still below his strike price). The trader was wrong about market direction, but finds the combination of decreased volatility and time decay has eroded the value of his option to the point that he can buy it back at a profit (or perhaps hold it until expiration).

Part 3 Will Be Posted On November 14th, 2008. So come back soon!

9 thoughts on “Traders Toolbox: Learning Options Part 2 of 4

  1. Yeah, sure: If one bought a 210 when the security is trading @200, he is quite likely to suffer time decay. The solution? Buy either one strike ITM, or several strikes ITM. One will get a much better delta. Too, any further move in the underlying in the direction one is trading in, will only mean sheer gravy if one bought ITM in the first place.

  2. Hi all,
    I liked your article and thought it was good. I would like to know if any one can help me understand the following:
    Lewis Borsellino in his book talks of buying 2000 call options on feeder cattle - he then says the price moved up towards / near his strike price but did not reached it - he then states that he should have shorted the underlying futures thereby locking in the differential between the two ???
    Can anyone explain the mechanisms of what he was trying to do - I am confused and do not understand how they off set each other ???
    Thanks for your time,

    PS Is it then possible to buy calles on etfs and then if strike price not reached to short the etf ?

  3. Options price has time value and intrinsic value. When the time passes by, the time value of the options will decay. That why, one should use strategies when buying options. For example using spread can offset the time decay value.

  4. In the example that you gave of a 210 call bought when the stock was selling for 200, would you not profit from an increase in premium by selling your call option when the stock moved to 205, even if it never reached your strike price of 210?
    A beginner

    1. An Call Option will increase in intrinsic value, only if the stock price rises ABOVE the strike price (if it is "In the Money (ITM)).

      In the example, the strike price is 210. The stock rises from 200 to 205. This is NOT above the strike price, therefore the option is "Out of the Money" (OTM) and there is no increase in the intrinsic value of the Call Option.

  5. Please i will like if you could sent to me a lession on how to trade options, crude oil and futures market i only trade forex market. your site is intresting. thank you.

  6. it is nice piece of information but provide very basic knowledge of options.
    any ways for beginers still worth reading it to develop right kind of attitude

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