Trading in options... like comets do...

Many day-traders like to trade in stock options. The key reason is that related returns are usually a huge percentage of the amounts invested in buying option contracts in the first place. On the downside, if things turn out opposite of what you hoped for, you might lose the entire amount you put in, at least if you don't get out early enough with some (relatively heavy) loss, instead of waiting for the tide to turn around.

Take a look at the Wikipedia article for basic info on options, if you wish to do so. And a myriad other sites as well. Here I am going to give you a dummy's view of options trading.

For quite a long I have been confused by the concept of trading in options as I seemed to forget time and again what the benefits and risks were of buying or selling the two types of common option contracts, calls and puts (search me how on earth they came up with such names). It wasn't until I got into trading in option contracts and felt the pain of losing quite a bit of money (and occasionally the pleasure of making some cash) that I finally (I think) managed to remember two things:

1. When you sell any options (either calls or puts) you get the benefit of the proceedings immediately (the day you sell)! However, the moment you do that, you force an obligation upon yourself as well. The obligation is to either sell (in the case of calls) or buy (in the case of puts) the amount of shares of the underlying stock at the expiry day and at the strike price of your contract, and that only if the party to whom you sold your options decides to exercise his/her rights. Because of this 'obligation thing', anyone selling option contracts must be covered by collateral for the sale to happen, in the form of either the amount of underlying shares concerned (for calls) or the cash to buy the shares at the strike price (for puts). Therefore, only 'loaded' capitalists' can afford selling options... like the ol' saying... money makes money!

2. As a rule, any investor expects to spend his/her money buying 'something' that he/she can sell later (as soon as possible) at a higher price (as high as possible) and pocket the difference as profit. In the case of options, many traders expect the option contracts they bought to soon appreciate, at which time they'd sell them, long before expiry. So, basically, if you decide to spend your hard earned money to buy either a 'put' or a 'call' contract, you'll wish and pray the underlying stock to move in one or another direction for you to make a margin on your investment. Which is this direction then?

In the case of puts, you make money when the stock goes down. Regardless what 'put' strike price you selected to buy, mostly all of the 'put' premiums appreciate when the stock moves south. If you look at any options table of a particular stock, provided free by many providers on the net during a trading day (Y!F being one of them), you'll see the 'put' tables all turn green on a day that the stock goes down. If you plot these premiums for each strike value along a vertical axis, it looks very much like a comet (or a cone) moving vertically downwards and heading towards earth collision! Click on the screen shot on the right for more detail and see what I mean.

Exactly the opposite happens with calls. Their premiums go up when the underlying stock price moves up. This time, the plot looks like a comet moving upwards, or like a launched space shuttle with its exhaust gazes right behind, forming a "comet's tail".

So, if you buy 'put' contracts you'll hope the stock to lose value for you to make money. For 'calls' however, you need to hold the graph I gave you upside down and see that you'll need the underlying stock to increase in value for you to make money (you need the shuttle to move upwards towards outer space!).

What happens when things turn different though? Meaning, you bought puts and instead of the price of the underlying stock moving down as you hoped, the sonovabitch moves upwards! Well, look at the graph again. The comet keeps its position pointing south but suddenly it moves upwards, like it put the motor in reverse (happens sometimes in SF movies). In that case, it's like you bought at 'b' and as the put comet moves in reverse your contracts only sell at a lesser 'a' and you then lose money (equal to b-a). Same sh*t with calls. You bought them at a price and hope for the shuttle to go for the outer space, but instead, like it's run out of fuel, it starts falling back to earth with tail and all, and its 'selling' price gets less than what you paid for.

When the reverse of what you expect happens, you better consider your odds, take your loss and get the hell outta there, or stick to it and potentially burn out. When things turn right for you though, and the comets move in the right (for you) direction, don't get greedy and get out of it as soon as you have a descent return. Once in a while miracles happen and the returns percentage is in the hundreds and even the thousands (happened recently to Google options as the stock picked up about 90+ bucks in a single day and few of its calls moved up by 18000%!)

So, next time you trade in options, think of my comets... puts 'move' down, calls 'move' up.