Basics of Options Trading

We've covered a lot on the stock market fundamentals and investing or trading of stocks as well as stock picks in general, so I thought I'll like to touch on a little on some basics on options trading. This can be quite complex for most beginners in the stock market, so I'll try to make it as simple as I can.

An option is a derivative of a stock, future, index or exchange traded fund which means that their value depends on the price of the underlying trading instruments as mentioned earlier. Every option has a strike price that is a certain price of the stock. The value of the options change relative to how close the strike price is to the current price of the underlying trading instrument. Every option has a limited life as well; it depends on it's expiration date. Once it is passed, the option will no longer exist.

There are basically two types of options: the call option and the put option. Options trading is all about these two types of options. When you buy call options, it means that you are bullish about the price of the underlying instrument and if you buy put options, it means that you are bearish about the price of the underlying instrument.

When you buy call options, you reserve the right to buy a stock at the strike price. When you sell call options, you are obliged to sell the stock at the strike price. Let's take a look at an example:

Andy purchases 3 call option contracts (the right to purchase 300 shares, 1 option contract is equivalent to 100 shares) with strike price of $30 for XYZ stock (Note that for every option buyer, there is a seller.  However, they do not deal in options trading with each other directly as their stock trading companies or brokerages do so through an exchange) when the XYZ was trading at $28. If the share price of XYZ soars to $40 by the expiration date, Andy can still purchase 300 shares of XYZ stock at the strike price of $30 (Take note, that's a profit of $10 x 300 = $3000 already!)  if he chooses to exercise his call options.

Now, the profits from the above options trading transaction may not seem very lucrative in absolute terms. The good thing is that he does not need to pay the price of the 300 shares of XYZ stock for the 3 contracts in the first place. For example, if Andy purchased the contracts when the price of XYZ stock was $28, he might only have to pay for the time value for the life of the option, which might have only been $7 for 6 months to expiration date. This means that he only paid $7 x 3 x 100 = $2100 for the 3 call contracts. Further calculations can allow us to conclude that Andy made a percentage profit of 142.3% for 6 months of work as compared to 35.7% if he had purchased the shares and held onto them for 6 months. See the difference between the two rates of returns in options trading and share trading?

Let's discuss about put options in options trading next. When you buy put options, you reserve the right to sell the shares of the underlying instrument for a certain strike price. When you sell options, you are obliged to sell the shares of the underlying instrument for a certain strike price. Let's follow this up with another example:

Andy now believes that the share price of XYZ is going to fall after reviewing it's price performance. Rather than short selling the shares (which carries a high risk as there is technically no ceiling to how high the share price can rise), he decides to engage in options trading of purchasing 3 put contracts with strike price of $38 and a expiration of 6 months at the cost of $6.50 with the current share price of $40.

Shortly after Andy's purchase, the share price of XYZ starts to tank on alleged accounting issues and incorrect reporting of it's previous quarterly results. Eventually, the share price of XYZ falls to $22 after 5 months and Andy decides to sell his option contracts. He makes a profit of $16 x 3 x 100 = $4800 which is a percentage profit of 246.2% as compared to 40% for short selling 300 XYZ shares and buying it back later. Again, we can see the huge difference in the returns from options trading and stock trading.

What happens when the current share price of XYZ is below the strike price of the option? For call options, it will be practically worthless as there is no intrinsic value (calculated by subtracting the strike price from the current share price) and the time value has dropped to zero (since the option as reached the expiration date). For put options, there will be an intrinsic value (calculated by subtracting the current share price from the strike price) and although the time value has dropped to zero, Andy's stock trading company or brokerage firm will exercise his contract and arrange for the sale of his shares at the strike price. If he does not possess the shares, his stock trading company or brokerage firm will buy from the open market and sell at the strike price. This is basically how options trading works.

A word of caution here! While options trading can amplify one's returns from the stock market, it can also amplify one's losses as well if not used properly. Hence, it is strongly advised that one should not start to engage in options trading unless one has mastered stock trading at the intermediate level; this means that you have to at least be making some money consistently by stock trading.

Another form of options trading which is much more dangerous than buying options is selling them. Although it is a strategy used by some good traders to make money consistently in the stock market, it can be very dangerous especially if the seller is selling call options naked, which means that he or she does not own the shares he or she is obliged to sell to the buyer. If the option is exercised, the seller will have to buy the shares from the open market at the current share price and sell it to the buyer of the option at the strike price.

That's all for the introduction to options trading for now. In the future, I will be posting on this topic of options again to explain the uses and how it can be safer than stock trading if used properly.

Tags: stock market, investing, trading, make money, stocks, finance, wealth building, stock market basics, options trading

How to invest in stocks in the current stock market scenario

The recent turmoil in the stock market has affected every investor who has invest in stocks. The recent ups and downs of the market has made it fairly difficult for mid term to long term investors to invest in stocks, so I'll like to touch on this issue and what to look out for in in order to still be able to make money in this market. The investor pessimism can be seen with the outflow of money from mutual funds out of the stock market into other types of financial instruments such as bonds. Dear beginner investors and traders, all is not lost! There may be a silver lining in the clouds after all.

As discussed in the previous articles, the first thing we have to do before we invest is any stock is to gauge the current stock market situation. Let's take a look at the 3 major stock market indexes, namely the Dow Jones, S&P500 and the Nasdaq Composite. These are the three indexes I use the monitor the strength of the stock markets.

Nasdaq Composite Index Watch

(Image courtesy of OptionsXpress. I invest in stocks with them :))

As you can see, the Nasdaq Composite has been trading within a range for the last six months or so. The resistance level (as seen by the trendline that the index has failed to penetrate from the upside, thus acting as a ceiling) is around 2300 or so while the support level (as seen by the trendline that the index has managed to stay above, thus acting as a floor) is about 2100 or so. I will mention about the circled regions later.

S&P 500 Index Watch

(Image courtesy of OptionsXpress. They provide a free on line trading software for their customers.)

As seen from the graph above, the S&P500 index has also been trading within a range for the last six months or so. The resistance level (as seen by the trendline that the index has failed to penetrate from the upside, thus acting as a ceiling) is around 1120 or so while the support level (as seen by the trendline that the index has managed to stay above, thus acting as a floor) is about 1040 or so. As mentioned previously, I will mention about the circled regions later.

Dow Jones Industrial Average Index Watch

(Image courtesy of OptionsXpress. I invest in stocks with them :))

As seen from the graph above, the Dow Jones Industrial Average index has also been acting in tandem with it's cousins in moving within a tight range. The resistance level (as seen by the trendline that the index has failed to penetrate from the upside, thus acting as a ceiling) is around 10700 or so while the support level (as seen by the trendline that the index has managed to stay above, thus acting as a floor) is about 9900 or so.

What can we conclude from all the analyses of these graphs if we want to invest in stocks?

The first important fact is that the stock market indexes seem to be trading within a range defined earlier. This is vital to know, especially when the stock market indexes are approaching these levels again as they might not be able to break through the resistance/support levels and will bounce off them once more. When this happens, we will notice a change in the trend again. You can prepare for this scenario in advance to protect your holdings or come up with strategies to take advantage of it.

The second important fact is that the stock market indexes are displaying strong volatility near the resistance and support levels (as seen in the badly drawn circles on the graphs). In fact, it is not surprisingly top have percentage changes of 2-3 percent in the days when the stock market indexes are near the support and resistance levels. As such, your portfolio can be greatly enriched or devastated in a matter of two or three days, depending on the type of stocks you happen to own at this time. Hence, it is important to catch the change in the trends quickly if you want to maximize the profits from the short trends that have been dogging the markets in the last six months. If you move too slowly, you will miss out a significant portion of the profits. That said, it is dangerous for beginners to move too quickly to a change in trends as they are often not experienced enough to tell whether it is genuine or not. Even experts make mistakes often in this type of unpredictable periods.

The third important fact is not shown on the graphs. The leading stocks (refer to my previous post on how to pick the best stocks for definition)that I track and buy or sell short have actually fared much better than the rest of the stock market indexes. The drop in price in terms of percentage was not as much and more importantly, the volume was low, thus signifying that the mutual funds and the financial institutions were not selling their shares but are hanging on to them. That is why I have not sold most of my holdings this time even though I usually advocate a must sell when the hit loss is at 7% or so. Within the last couple of days, my portfolio stock picks have recovered all its losses and are even showing some profits. Judging from the stock market index charts and barring any unfortunate events, the indexes should continue to rise until they are near their respective resistance levels. That is when I will monitor extremely carefully to see what comes up next. I do not make any predictions but will simply act based on the current stock market situation.

To summarize on how to do well in this unpredictable period, an investor who wants to invest in stocks must always have a keen sense of the market and how it is behaving, as well as the behavior of superior stocks that he/she has on his/her watchlist. Always have plans in place when the indexes approach their resistance or support levels and react accordingly to what happens next. If this is done well, there is huge money to be made if one decides to invest in stocks.

Tags:stock market, investing, trading, make money, stocks, finance, wealth building, stock market basics, invest stock

Stock Picks 1: How to choose the right time to pick stocks

One of the most important skills for a trader or an investor is to be able to have profitable stock picks. Selecting profitable stock picks is certainly both an art and a science (and certainly not an easy thing to do) and that is why many people are not able to do it well. However, it does not mean one is not able to do well consistently. It takes years of practice and monitoring to be good in it.

Before we can do stock picks profitably, we must remember what we have learnt about the nature of the stock market. This is because no matter what stocks picks we have, it will not be profitable if we go against the current condition of the market.

What drives the stock prices up or down? If you have read to my previous post on Stock Market Basics 101 and the stock market timing guide, you will know that the big boys (aka the financial institutions, mutual funds and exchange traded funds) are responsible for the upside and the downside of the market. Now, the interesting thing to note is what they actually do to bring down the market indexes.

Before that, let's understand how the big boys do their stock picks. What they do is that they make their purchases or sales in several large blocks that can last from days to several weeks. This is to prevent the stock price from getting too expensive to buy or too cheap to sell off as people can easily follow their lead if they do it all at once. They will also stock picks from the same sector or industry at once as they seldom purchase a particular stock only. When this happens, you can notice that stocks in a sector start to rise, thus resulting in the laggards rising in sympathy with the group leaders. However, when they do that we retail investors can follow their tracks easily by checking for the volume that accompanies the stock price change. If the volume is higher than average significantly, say 30% or so we can be sure that the financial institutions are behind this. That is why we should always check the volume together with the change in stock prices too determine the reality of the situation.

What actually happens is that some of the big boys will start selling a number of stocks in large amounts (these stocks are usually related by sectors, say the tech sector and so on). When the selling power overwhelms the buying power, the prices of the stocks start to slide as a result. This will result in the the index being unable to rise, in fact it starts to slide as the selling "gravity" starts to act on the indexes. As the indexes go down, this weighs on all other stocks and their prices start to follow south as a result. If there is serious net selling, the drop in the indexes will be accompanied by a rise in volume, especially if the volume is greater than the previous day and greater than average.

The converse is true for a rise in the indexes. When the big boys start to purchase several stocks in large amounts over several weeks, the stocks' prices start to rise and this will lift the indexes. As the indexes go up the other stocks will tend to follow (a rising tide lifts all boats). If the net buying power is strong, there will be a good rise in the indexes followed by good volume.

The first golden question on stock picks is this: How do we differentiate the stocks that have been bought and those whom are lifted by the tide? Check for the rise in price followed by good volume. If the stock rises strongly in above average volume ( minimum 30%) this is one that the financial institutions and mutual funds are targeting and are buying. Note that one day of accumulation will not be enough to state that the big boys are buying. There should be at least two days within a space of a few weeks. Similarly, if we are looking into shorting we should be looking for stocks that are selling off in big volume. This tells us the big boys are doing as such and we should be doing the same too.

Before we get to the first rule of profitable stock picks, we need to know what exactly is the essence of profitable stock picks. If you have not realized it by now, it is to actually to decipher what stocks the financial institutions/mutual funds/exchanged traded funds are buying or selling and join in the ride. It can be done as remember, the big boys actually do their buying or selling over several weeks and we do not have that restriction. Learn to read the footprints and get in early way before the selling or the buying is done.

Thus the first rule of profitable stock picks is as such:

If you are going long in an uptrend market, purchase stocks that are rising in strong volume over a few days as these are the reasons why the indexes are rising.

If you are shorting in a downtrend market, sell short stocks that are falling in strong volume over a few days as these are the reasons why the indexes are dropping.

When a stock price rises with the rest of the market but in weak volume, it is merely rising with the tide and should not selected as one of your stock picks. Similarly, when a stock price drops in weak volume, it is not the target of the financial institutions/mutual funds/exchange traded funds and should not be considered a short selling candidate.In fact, the stock might have the power to do exactly the opposite and burn a big hole in your pocket.

Ok, this concludes part 1 of the stock picks series. I will be posting the part 2 within the next two weeks (my work is keeping me a little busy right now). Thanks for reading and hope that you have learnt something on stock picks that are valuable! :)

Tags: stock market, investing, trading, make money, stocks, finance, wealth building, stock market basics, stock picks

A Stock Market blog for beginners... by a disciple

Welcome to the Stock Market Blog for beginners! This is not one of the usual sites that promotes their "never fail" systems and strategies, mainly because I am not an "guru"... I consider myself a Stock Market disciple who has started from the beginning like you are now and have learnt the hard way to have achieved a certain measure of success. I will share what I can in the future posts.

Disclaimer: I do not guarantee that anyone who reads this blog can make a lot of money and become an expert in a short time. Investing is a skill that can be learnt but it takes a lot of hard work and time to become really good and there is no one in the world that can tell you he/she can make money consistently over decades without doing much. Even experts make mistakes sometimes when they get too caught up by their emotions. However, I am sure that beginners in the stock market can learn some useful stuff to help them in their journey to become good or even great investors. :)

Tags: stock market, investing, trading, make money, stocks, finance, wealth building, stock market basics