how do you trade stock options?

Question

is there a bigger risk to trading options than just stocks?

Answer 1

I don't. Not every stockbroker has an options specialist, but the larger ones online may have. They are sold through investment firms, but an options specialist has more training than a Registered Representative, or stockbroker.

Yes, there is a much bigger risk, but your risk is the amount of your option price and the transaction costs.

The only investment vehicle which is more risky is a futures contract or a forward contract. Investing in a hedge fund runs a close second to trading futures contracts(USA) or forward contracts(Europe and parts of Asia).

Be very, very careful.

Answer 2

Options have different characteristics than stocks, and there is a lot of terminology beginning option traders must learn. Two types of options are calls and puts. When you buy a call option, you have the right but not the obligation to purchase a stock at the strike price any time before the option expires.

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Answer 3

Just like stocks, through a discount broker. You should learn about them before you trade them. Typically, your broker will require you to acknowledge that you have read and understand the risks associated with stock options before they will let you trade them. They are a little trickier than buying and selling stocks.

Answer 4

Options are not marginable therefore they have no loan value which means they can not be used in a margin account. If you are going to to covered calls you will need the security or equivalent. Most listed stocks are marginable which means they have loan value for margin purposes. But using other securities for covered calls is not practical since securities only have 50% loan value in meeting a margin call while you could just deposit the underlying security to cover a call writing. Most investors do not, and should not use margins, it's not a good practice to use margin either for trading and investing unless your well versed in the rules & regulations of margins.

Answer 5

On a dollar for dollar basis, options are less risky than stock over a given period of time. For example, if you think Microsoft is going to increase in value over the fix two months after release of Vista, you can either buy the stock for around $29.50 per share or buy a $30 strike Jan '07 call for $0.70 per share. Now an option covers 100 shares, so the option cost is $70.00 to control 100 shares versus $2950.00 to own 100 shares. If the stock goes up to $30.00 per share the option will be at about $0.92. You can calculate this using an option pricing calculator http://www.volatilitytading.net/optioncalculator.htm. That is a 30% return on the option and a 1.7% return on the stock. That is leverage. By the third Friday in Jan '07, if Microsoft goes to $35.00 then using your call, you can buy the stock at $30.00 or you can just sell your call for $5.00 - 700% return on option.

What if Microsoft drops? If it drops by $5.00 to $24.50, you have lost $5.00/share on stock but most you loose on call option is what you paid or $0.70 per share. So that is much less risk than owning stock if you are wrong and the stock goes down.

When you are long (buy) an option your risk is always limited to how much you paid and is always much less risk than owning the stock. The high risk in options comes in when you short (sell) options and you do not own the stock for a call you sell or have the cash for a put you sell.

A good example of that is the recent bankruptcy on Winn-Dixie. Their stock value is now zero so anyone who owned the stock lose everything. The people who owned a put option collected cash, equal to strike price of put option, from the people who sold the put options. Notice it is a zero sum game.

Options can be used to reduce you risk in stock ownership. If you own a stock that is not moving (which most stocks do about 80% of the time), you can sell a call option against it at a strike price higher than your basis. For example, assume you paid $25/share for stock and sell a $27.50 strike call option for $0.50/share. If the stock goes to $27.50 at expiration of option, you have to sell the stock at $27.50 and would make total of $3.00/share ($2.50 on stock and $0.50 on option). If the stock goes down or does not move above $27.50 by expiration, you get to keep the stock and the amount you made by selling the call option. That is like generating your own $0.50/share dividend. Also reduces your basis by the $0.50/share so now most you can lose on stock is 24.50, not the original $25.00.

So to sum up the answer to your question, options trading done correctly is much less risk than stock and allows you to diversify much better with same amount of capital. The risk in options that is not present with stock is their limited lifetime. They do expire, so your forecast for stock move has to happen within the time frame of the options you use. This can range from 1 day to almost 3 years.

Warren Buffet routinely makes use of options to reduce risk in stock and to acquire stock at a reduced basis. If he is using them, they must be lower risk than just owning stock. You can even trade stock options in your IRA.

Answer 6

In terms of the risk, it exists with every Financial product that is not FDIC Insured. If you are looking to increase your knowledge, check out www.investopedia.com, as you can learn about any/every financial product that exists out there.