What are options?

An option is a financial derivative that represents a contract sold by the option writer to the option holder. An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties. The contract signifies a buyer’s right, but not the obligation, to buy or sell a financial asset. The asset must be bought or sold at an agreed-upon price stated in the contract. This price is called the strike price. The transaction must take place during a certain period of time or on a specific date, known as the exercise date. If an option is not exercised by the exercise date, it expires and no longer has value.

Why use options?

Options are useful because of their versatility. Traders use options to speculate, while hedgers use options to reduce the risk of holding an asset. Options can provide investors with more alternatives, allowing them to specify the exact amount of risk they are willing to take in their holdings. Options can also be used as alternatives to stock investments (one option for each 100 shares), giving investors the ability to profit with lower potential risk due to a lower initial investment.

How do options work?

An option premium is the price of the option. It is the price the buyer pays to purchase the option. The price of an option is determined by several factors. These include the overall investment markets and the economy at large, as well as the supply and demand in the market where the option is being traded. The price is also affected by the underlying instrument, its traditional behavior, and its volatility. It is important to note that most options are never exercised- holders choose to take their profits simply by trading out of the options.

What are the types of options?

There are only two types of options: options that can be bought, and options that can be sold. A call option is an option to buy a stock at a specific price on or before a certain date. Call options are like security deposits, and their value usually increases as the value of the underlying instrument increases. When you buy a call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price, called the strike price. If you decide not to use the option to buy the stock, your only cost is the option premium. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

Put options are options to sell a stock at a specific price on or before a certain date. Put options are similar to insurance policies because you are insuring a stock by fixing a selling price. Puts are also very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires. A call option is considered “in-the-money” if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless.

How can SmarTrend be used for options trading?

Since SmarTrend provides subscribers with short-term trend predictions that range anywhere from 15-45 days, experienced option traders can use our UPTREND to purchase call options that are either front month or one month out. Call spreads are another viable strategy that would be slightly less risky. The choice of strike price ultimately depends on the risk tolerance of each investor but could range from deep in the money calls, to slightly out of the money. Given the near term nature of our trend calls, going to far out of the money may not be as desirable.

Similarly, our DOWNTREND calls can be used to purchase put options or put spreads using similar time periods and strikes. Further, if an investor is long a certain stock, a DOWNTREND signal could be used to purchase put protection (or perhaps sell an out of the money call) should prices fall and should the investor not want to sell his or her shares for other reasons.