Options Quiz 1

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Options and derivatives are easily the most complex of the various investment related subject matter. Even those who do understand them, often find themselves perplexed by the more advanced features of some of these esoteric financial instruments. Those who don't understand them often claim that they are merely speculative instruments and are somewhat akin to gambling. However, this is not true at all. An option instrument and other similar derivatives can serve an important purpose in any investment plan.

Believe it or not, using them often gives protection against risk rather than adding to it. The following series of articles will explore the investment uses for derivatives and how they can be integrated as a part of any investment plan. Before we go more in depth with the articles, you can review the following responses to common questions about these esoteric investments. Just like anything else, what stocks are available in the options market depends on demand.

Thus, options are typically available on the more well know and highly traded stocks but not on those which are obscure or have light trading volumes. Most options strategies revolve around profiting on major swings in a stocks price?

In fact options option question stock trading a bit more versatile than most believe. They can be used to generate income or to protect the value of a portfolio just as easily as they can be used to generate profits on the price fluctuation of the underlying stock. Options have no place in the portfolio of the conservative investor?

This may seem to be the case and many conservative investors will certainly believe it to be so, but the truth is options can provide added security and portfolio diversification in almost any portfolio. Thus, it is possible for a conservative investor to employ them as part of a strategy for wealth preservation as opposed to speculative trading. Why do they call them "options"? Because an option is exactly what they are.

They give the buyer an option to buy or sell an underlying security at a specific price, at a specific time. See the more in depth article for an explanation of how this works.

Is the buyer compelled to do anything when he purchases an option? This is important to understand. The buyer of an option is not required to do anything with that option. He is always able to let it expire by taking no action. Therefore, those who fear they will be required to buy the underlying shares of a call option can rest assured that there is no obligation to do so. What does it mean to "exercise" an option?

When an option is "exercised" then the underlying transaction takes place at the specified price set out by the option contract. Thus, the owner of a call option would buy the underlying shares at the price set out in the contract. By the same token, the owner of a put option would sell the shares option question stock trading the underlying price.

Can the buyer of option question stock trading option exercise it anytime option question stock trading wants? This depends on the type of option it involves. There are two forms of options on the market. There option question stock trading American style options, which allow an individual to exercise the option anytime up until the expiration date, and there are European style options, which only allow the owner to exercise the option on the date of expiration.

How do Index Options differ from other options? Index options trade on the aggregate option question stock trading of an entire stock index. As a result there are special rules and considerations, which must be understood before investing in these types of financial instruments.

See the more in depth article for details on Index Options. When is a put option "in the money"? Put options are considered to be "in the money" when the option question stock trading price is below the exercise price. When is a option question stock trading option "in the money"? Call options are considered to be "in the money" when the share price is above the exercise price. Information is for educational and informational purposes only and is not be interpreted as financial or legal advice.

This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor. Common Questions about Stock Options and Derivatives Options and derivatives are easily the option question stock trading complex of the various investment related subject matter.

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Whenever we contemplate a trading opportunity where we are considering using options there are three key questions we must answer:. First , with respect to the price of the underlying asset, do I believe that it is most likely to go up, down, or sideways; or do I expect a large movement but with unpredictable direction the opposite of sideways?

Second , completely separately from its price, what do I believe about the implied volatility of the underlying asset? Is it most likely to increase, to decrease or to change in an unpredictable fashion? The more they expect it to move, the more they will pay today for all of its options, both puts and calls. Third , how aggressive or conservative do I want to be? A very aggressive trade has a large potential payout, if it works. That large potential reward always comes at a cost.

That cost may take the form of a high probability of failure. Or, it may involve a potential loss that is large in size or even unlimited. A more conservative trade, on the other hand, has a smaller potential gain and also less risk. Any particular option trade, with its own choice of underlying, strategy, expiration, and strike prices, always falls on a continuum from very aggressive to very conservative.

If we go all the way down the conservative route, we eventually get to a type of trade that is guaranteed not to lose but is also guaranteed to pay only the same return as we could get on treasury bills — in other words, a trade not worth the bother. Our option trades can be constructed to have just the degree of aggressiveness that is appropriate to us, but we must know how to do it or ask the right questions. Most new option traders are clearly aware of the first question about the underlying asset price.

Almost everyone knows that call options go up in value when the underlying goes up, but as a larger percentage, and that put options go up when the underlying goes down, also amplifying that move.

It is the second and third questions that trip up many new option traders. Many, for example, do not understand sufficiently just how important the level of IV is to the success of their trade, or that being too aggressive or too conservative can hurt them as well.

The simplest option trade that one can imagine would be to buy call options on a stock when we think it will go up. In the worst case, if we are wrong, we are out only the cost of the call option.

If we are right, we have potentially unlimited profit and the calls should increase by a larger percentage of their cost than the stock itself does. It seems simple, but there is more to this apparently simple trade than meets the eye.

In fact, a call option can go down in value when the underlying stock goes up. This is because the stock price is just one of the three main forces acting simultaneously on every option at all times.

The other two are:. And all three of these forces act differently on every call option for the same underlying asset depending on which strike price and expiration date we choose.

In our Professional Option Trader course , we teach a straightforward, step-by-step method of selecting the particular strategy and the specific options to use in any situation.

This method takes into account the expected effects of all three of these main forces. So, it is clear that what seems like a dirt-simple strategy, buying calls on stocks on which we are bullish, has a bit more to it than it would first appear. Can it be done profitably? With the right identification of the bullish opportunity in the first place, and the selection of the strike price and expiration to take into account all three forces, it can.

The important thing is to get yourself educated. For comments or questions on this article, contact us at help tradingacademy. What Really Makes Markets Move? Disclaimer This newsletter is written for educational purposes only.

By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

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