Options trading is the most flexible financial instrument that exists. This is a financial instrument which can be used to buy or sell in the future at a specific price, but without having necessarily to go ahead with the deal if you no longer feel it is a good deal for you.
Let us illustrate it with a more mundane example. Imagine you see a house you would like to buy. You have a hunch that the neighborhood it is in will become popular in the next year and you think the interest rates will drop, and drive house prices up. So you tell the owner you want to buy his house in a year at the current market price with a percentage premium on top to sweeten the deal. He agrees, and you give him a deposit to close the deal. The year goes by, and your prediction does not materialize, the neighborhood is still part of the ghetto, so you just drop the deal and walk away. However, if the market had gone your way and the house was worth ten times its initial price, the owner would still have been obliged to sell at the agree price.
You do not need much imagination to see how this trading instrument can provide a unique opportunity for traders to create profitable trading strategies. However, it can also be a daunting and confusing place to find yourself if you are beginner to this type of trading. This is because options trading is a multidimensional process. If you do not understand one of the stages you are not going to get the whole picture, and you are very unlikely to become a successful trader.
In order to understand options trading you must be comfortable with three of its main elements: direction, duration and magnitude. Understand these three factors, and you are one your way to becoming a successful options trader.
Direction.
This refers to what the underlying security, stocks, bonds, or whatever you are trading, is doing. It can move up, down or even sideways. This is where an investor has to make his educated guess of how the market will behave.
Duration.
Duration is the time it will take for the change in direction to occur. It is not only a matter of predicting if the underlying security will raise or drop, but when it will happen also.
Magnitude.
This element refers to how big the move will be. Will the price drop by a few points or a hundred.
A profitable options trading position requires all three elements to work together. It is no good being able to predict the direction of the price of a particular stock if you do not know when a move will happen or how big that move will be. Not understanding how these three elements work together is the main reason people lose money on the market.
In order to create an edge for yourself in such a competitive market it is important to not only be able to place a put or a call but be able to combine options. So, before you start making calls to your broker it is a good idea to at least have a working knowledge of what spreads, straddles, and various options combinations are. In this blog we will be looking at a few of these elements and explaining how they can be used to further your investment.
However, there are some general guidelines on how to use direction, duration and magnitude to your advantage when trading with options.
1) Give yourself time. If you are going to bet on the direction a security is going to take give yourself time to be right. Long term equity anticipation securities, also known as LEAPS are good for this strategy because they are options that have expiration dates that are further than nine months away.
2) When getting involved in options combinations make sure you sell expensive options, with a high volatility, and buy cheap options, with a low volatility. This is a principle used by all merchants, whether of stocks, potatoes or wine bottles. Buy cheap; sell expensive.
3) Time can be your friend. Always buy options that have plenty of time left till expiration. This way you can play with the leverage it provides and take advantage of the time decay factor of an option.
