Trading Options For Dummies
Trading options is a bit different from trading stocks, but they both require research and study. If you're going to trade options, it's important that you know order types, how to read changes in the market with charts, how to recognize how stock changes affect indexes and options, and how indexes are built.
Trading Order Types
A variety of order types are available to you when trading stocks; some guarantee execution, others guarantee price. This brief list describes popular types of trading orders and some of the trading terminology you need to know.
Market order: A market order is one that guarantees execution at the current market for the order given its priority in the trading queue (a.k.a., trading book) and the depth of the market.
Limit order: A limit order is one that guarantees price, but not execution. When placing a limit on an order, it will be treated like a market order if:
When buying, your limit is at or above the current market ask price and there are sufficient contracts to satisfy your order (for example, limit to buy at $2.50 when the asking price is $2.50 or lower).
When selling, your limit is at or below the current market bid price and there are sufficient contracts to satisfy your order (for example, limit to buy at $2.50 when the asking price is $2.50 or higher).
Stop order: A stop order, also referred to as a stop-loss order, is your risk management tool for trading with discipline. A stop is used to trigger a market order if the option price trades or moves to a certain level: the stop. The stop represents a price less favorable than the current market and is typically used to minimize losses for an existing position.
Stop-limit order: A stop-limit order is similar to a regular stop order, but it triggers a limit order instead of market order. While this may sound really appealing, you’re kind of asking a lot in terms of the specific market movement that needs to take place. It may prevent you from exiting an order you need to exit, subjecting you to additional risk. If the stop gets reached, the market is going against you.
Duration: The two primary periods of time your order will be in place are
The current trading session or following session if the market is closed
Until the order is cancelled by you, or the broker clears the order (possibly in 60 days — check with your broker)
Cancel or change: If you want to cancel an active order, you do so by submitting a cancel order. Once the instructions are completed, you receive a report notifying you that the order was successfully canceled. It's possible for the order to already have been executed, in which case you receive a report indicating that you were too late to cancel, filled with the execution details. Needless to say, you can’t cancel a market order. Changing an order is a little different than canceling one because you can change an order one of two ways:
Cancel the original order, wait for the report confirming the cancellation, and then enter a new order.
Submit a cancel/change or replace order, which replaces the existing order with the revised qualifiers unless the original order was already executed. If that happens, the replacement order is canceled.
Charts Used for Tracking Investments
Price data is used in charts to give you a view of market trading activity for a certain period. The following list gives you the lowdown on some of the chart types you might encounter while you track your investments:
Line chart: This chart uses price versus time. Single price data points for each period are connected using a line. This chart typically uses closing value. Line charts provide great big picture information for price movement and trends by filtering out the noise from the period’s range data. One advantage to line charts is that more minor moves are filtered out. A disadvantage to line charts is that they provide no information about the strength of trading during the day or whether gaps occurred from one period to the next.
Open-High-Low-Close (OHLC) bar chart: This chart uses price versus time. The period’s trading range (low to high) is displayed as a vertical line with opening prices displayed as a horizontal tab on the left side of the range bar and closing prices as a horizontal tab on the right side of the range bar. A total of four price points are used to construct each bar. OHLC charts provide information about both trading period strength and price gaps. Using a daily chart as a point of reference, a relatively long vertical bar tells you the price range was pretty big for the day.
Candlestick chart: This chart uses price versus time, similar to an OHLC chart with the price range between the open and the close for the period highlighted by a thickened bar. Patterns unique to this chart can enhance daily analysis. Candlestick charts have distinct pattern interpretations regarding the battle between bulls and bears that are best applied to a daily chart. They also incorporate inter-period data to display price ranges and gaps.
How Financial Indexes Are Constructed
To help understand financial index changes, you should know how indexes are built. Indexes are not created equal (well . . . one is). Financial indexes are constructed in three different ways:
Price-weighted: Favors higher-priced stocks
Market cap-weighted: Favors higher-cap stocks
Equal dollar-weighted: Each stock has same impact
How Changing Stock Affects Indexes
A financial index is a measuring tool of prices for groups of stocks, bonds, or commodities. A change in one stock translates into index changes. Some examples are:
When a high-priced stock declines in a price-weighted index, it leads to bigger moves down in an index when compared to declines in a lower-priced stock. The Dow is an example of a price-weighted index that is affected more by Boeing (trading near $100) than Pfizer (trading near $25).
A market-cap weighted index, such as the S&P 500, is impacted more by higher market capitalization stocks regardless of price. Even though Microsoft may only be trading at $30 per share, its market cap is huge — about $290 billion. When it moves up or down it creates a greater change in the S&P 500 than, say, Amgen, which trades at $55 per share, but only has a market cap of approximately $64 billion.
All of the stocks in an equal-dollar weighted index should have the same impact on the index value. In order to keep the index balanced, a quarterly adjustment of the stocks is required. This prevents a stock that has seen large gains over the last three months from having too much weight on the index.