How to Differentiate between Trading Option Styles - dummies

How to Differentiate between Trading Option Styles

By Joe Duarte

Besides individual stocks index options are also an important part of the market, which may be of interest and use to you at some point in your trading life. The most important fact at this point is to understand the major differences between options on indexes and individual stocks. Here are some important general facts:

  • You can trade stocks but you can’t trade indexes.

  • The dates for exercise (of your option rights) and the last trading date for the option are the same for individual stocks, meaning that they fall on the same date. These two important dates can be variable for index stocks, meaning that you may be able to trade the option on a different day than the exercise date.

  • There are two types of options: American and European style. Each has its own particular set of characteristics that will affect your ability to make decisions about exercise. Always know which style option you are using and the particular factors associated with it before you trade.

Using options to limit your risk

Getting the details of option risk profiles is important and will be useful. But actually devising and using strategies in trading is even better. You start by evaluating the many options that are available for asset protection.

And although you may not think that is sexy, spending the time up front to figure out what options work better than others in different situations isn’t only a good step in your learning process, it’s also practical. When using options to limit your risk:

  • You can reduce risk for an existing position partially or fully and adjust the hedging process gradually based on changing market conditions.

  • You can reduce risk for a new position to a very small amount by using a combination of options or by using single long‐term options.

You will need a margin account for these strategies, and you can get one by filling out and signing the margin account agreement that you obtain from your broker. These are complex strategies that you can work toward as you gain experience. Some of these more complex strategies include

  • Vertical debit spreads

  • Vertical credit spreads

  • Calendar spreads

  • Diagonal spreads

The most influential factor on when to use these spreads will be market conditions.

Applying options to sector investing

One of the best recent advances in the financial markets has been the creation and proliferation of ETFs. Through these vehicles, you can make sector bets without having to drop down to the individual stock level of decision‐making or research beyond some basic steps. ETFs are great trading vehicles because

  • You can trade them like stocks. That means you can buy and sell shares in them at any time during the trading day instead of waiting until the market closes, as with non‐exchange traded traditional mutualfunds.

  • ETFs offer listed options. That means you can apply all option ­strategies to sectors of the stock market by trading options on the underlying ETF. This often lets you make index bets without using index options with expiration and last day of trading may cause you some extra steps.

  • There are ETFs based on commodity indexes. These let you participate in commodity markets without trading futures. When you add the extra dimension of options being available, you have a nice array of different strategies available.

ETFs are an excellent trading vehicle category, for all those reasons and more. You can design entire diversified portfolios with ETFs and then use options to hedge individual positions or the entire portfolio.