Exercising the Option to Buy or Sell

What Options Can Do

Options trading on the stock market is an additional way to diversify your investment portfolio. This differs from trading options and futures on commodities.

Stock market options trading involves contracts which give an owner the opportunity to buy or sell a security at a fixed price either before, or on, the date the contract becomes due. Investors can either trade the security itself, or trade the option. Some investors choose to use options trading as a hedge against losses in other segments of their portfolios.

Let’s take a look at exercising the option to buy or sell a particular stock for which you have a contract. You have any time up until the contract’s expiration date to decide what you want to do. You can either take the stock or sell them at the price fixed on the contract no matter what their current value on the market might be.

Consider this example in options trading. There is a stock you have had your eye on and because of your research and analysis of historical trending reports, you believe the price of these stocks will rise. Should you be concerned that the price may not rise as you expected, you would probably wish to buy a call option that is close to the price on the current market.

Before that option expires, the stock price may increase quite a bit. In that instance, you would exercise the option to buy at the lower contract price.

Conversely a put option gives you the right to sell at a fixed price. You would buy a put option if your research indicated the stock price would likely fall.

Now your options trading choice is whether to keep the stock and its built-in gains, or sell it and take your profit. Of course, there will be fees due out of this profit which pay for the cost of the option itself, taxes, and brokerage commission.

Options trading is not as straightforward as you might believe. The beginning investor would do best to use a good deal of caution and the benefit of a mentor’s experience before attempting to profit from options trading. Mentors can help save you all the pain of making unnecessary losses, so I suggest you find one, and grab a book to learn from.

Straddles - A Neutral Options Trading Strategy

Previously, I have tackled directional options trading with Credit Spreads. Directional Trading means trading the markets or a specific stock with a specific view of it going up or down (bullish or bearish). This week, I'd like to focus on a different options trading strategy called Straddles.

A Straddle is a neutral or non-directional options trading strategy. In essence, neutral or non-directional options trading strategies are opted by options traders when he has no idea as to whether a particular stock would rise or fall. In such options trading strategy, the profit potential is assessed on the basis of speculative volatility of a particular stock price. There are 2 types of straddles: a Long Straddle and a Short Straddle. This post will cover the Long Straddle as an options trading strategy.

Long Straddle

A Long straddle is basically comprised of a Buy Call and Buy Put Options. The idea is you are buying a call and a put on same strike price. With this options trading strategy, if the market goes in one direction, one of the options will increase in value significantly, and the other will become worthless. For a long straddle to be effective, the price of a stock should either take a huge jump or go for a steep decline. This is very handy for times when the market is very volatile, and the volatility can enable you to earn unlimited amounts based on how much the stock price has risen or fallen.

Profits are calculated based on where the stock price is. If the stock price is above the strike price of the option, then the profit will be as follows:

Price of the stock - Strike Price of the Call option - Net Premium Paid

If the stock price is below the strike price of the option, then the profit will be as follows:

Strike Price of the Put Option -Price of the stock -Net Premium Paid

For example:
Company XYZ is trading at $40. You do a straddle by buying 10 call and 10 put options of $40. You paid $400 in premium.

If at expiry date the stock price is now at $50, then your profit is as follows:
($50 x 10 contracts) - ($40 x 10 contracts) - $400

If at expiry date the stock price is now at $30, then your profit will be:
($40 x 10 contracts) - ($30 x 10 contracts) - $400

If the stock price did not move at all by expiry date, you lose the premium you would have paid, and both options have now expired worthless.

If you would like to learn more about Straddles and options trading in general, I found that Planet Wealth provides very comprehensive information on stock and options trading, and the various strategies that you can use depending on the market situation.

On my next post, I will be covering short straddles. I hope you've enjoyed this post and learned something from it.

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