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« Pan American Silver Corporation: Up 11.65% | Main | Gold Stocks: Too far, too fast! »
Tuesday
Jul012008

Options trading: A few notes!

COBC picture 02 July 2008


We have had a few requests regarding options trading so we have put together a few notes on the subject with a few links to web sites that explain options in a lot more detail.

As we see them, an options contract is a bet that the underlying commodity or stock will go either up or down.

If we think that the stock we have in mind is going to go up then we would buy a Call Option, if we think that it is going to go down then we buy a Put Option.

An option is the right to buy, but not the obligation to buy that stock for a stated price on a given date in the future. Our call options on Kinross secured the right to buy Kinross stock in January 2009 for $20.00 per share. In this case each contract contained 100 shares, however do check with your broker as things can vary depending on which stock exchange you are trading on, etc. The attraction for us is that we were getting control of 100 shares for around 10% of the cost of actually buying them. As the stock appreciated so did the price of the option and we were able to generate a profit. However had the stock price depreciated then our options would have also depreciated.

Before buying an option we need to get the direction of the commodity right, choose an associated stock that is oversold and decide on a time period that we think is sufficient for the trade to work. The mechanics of the trade are not difficult to master if we keep it simple. However there some very sophisticated trading strategies available to us and they are deployed by experienced traders. You will see terms such as butterfly, covered calls, naked calls etc, which you can learn about as your understanding of options trading increases. Also remember that an option has a limited life span and then it expires and becomes worthless, it is not an investment that you can buy and hold and wait forever for it to recover.

This is a link to the Chicago Board Options Exchange, which is a useful site.



You can also visit Investopedia by clicking this link.



This is the sort of thing you can expect to find:

A financial derivative that represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (excercise date).

Options are extremely versatile securities that can be used in many different ways. Traders use options to speculate, which is a relatively risky practice, while hedgers use options to reduce the risk of holding an asset.

In terms of speculation, option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security.

For example, because the option writer will need to provide the underlying shares in the event that the stock's market price will exceed the strike, an option writer that sells a call option believes that the underlying stock's price will drop relative to the option's strike price during the life of the option, as that is how he or she will reap maximum profit.

This is exactly the opposite outlook of the option buyer. The buyer believes that the underlying stock will rise, because if this happens, the buyer will be able to acquire the stock for a lower price and then sell it for a profit.

You can also try the OIC (The Options Industry Council) just click here, where you find will various definitions such as the following one:




What is an Option?

An option is a contract to buy or sell a specific financial product officially known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.


Please talk to your financial adviser before entering into any options trades it is vitally important that you understand the risks involved. It can be a gut-wrenching ride and it certainly isn’t for everyone. Be prepared to lose the total amount that you paid for an options contract, it often happens.


Hope this helps!

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Reader Comments (5)

I was thinking more along the lines of a spread in place of a single call - less risk & less cost to play.

Buy the JAN 35 calls and sell the JAN 40 calls. Just like a single call if the stock tanks, your investments go down. But you received cash for the sale of the 40 calls up front. If you, take your profit after 50% or 100% the spread is not too much of an impact.

Your thoughts?

July 2, 2008 | Unregistered CommenterBC

The spreads between the bid and the asking price can be huge, so a lot depends on what you pay for your contracts and what you get for the calls that you are selling. Having sold the Jan 40 calls you have limited your profit potential, although if this type of trade suits you then fine.

Please let us know how it works out for you.

July 2, 2008 | Unregistered CommenterGold Prices

Bob,

I read this: "The main difference between warrants and call options is that warrants are issued and guaranteed by the company, whereas options are exchange instruments and are not issued by the company. Also, the lifetime of a warrant is often measured in years, while the lifetime of a typical option is measured in months."

Source: http://www.investopedia.com/terms/w/warrant.asp

Not sure what "guaranteed" means. Options trade on same exchange as stocks but different from options, right? Do you know of any quality gold warrants? Yamana's warrants are expiring soon; I think it is later this year.

Are warrants preferred since they have a longer time frame? No clue about leverage in comparison to option.

ep

July 3, 2008 | Unregistered Commenterep

ep,

Some of our readers invest in warrants - it comes down to the individual's preference. We also know some traders who buy options with only days left to run as their research suggests that a price is about to change fast in the very short-term. We can only pick the shots that fit with our criteria and objectives. If what we do helps you from time to time then it is a true win-win situation, which gives us a boost.

July 3, 2008 | Unregistered CommenterGold Prices

A spread could be 2 transactions. My "options friendly" broker will let me buy and sell the spread. Yes this caps my max return. Same is true if you put the sell order in at 100% profit after the purchase. I can find spreads with a 100% profit potential. Also, I look for tighter bid ask spreads and will post a limit order that splits the difference and it will often go.

In this case I bought single KGC, HL & PAAS options, not the spreads. This was because I was very very very comfortable with these 3 companies. I have since sold the KGC & PAAS and half of the HL. These trades were perfect, thanks gold-prices team for the research and suggestions.

A spread and a single option each have advantages and disadvantages. Neither is the ideal in every case. My broker www.thinkorswim.com has a great set of educational resources and will set you up wiht a paper account to play with. All you need to do is register to access the education and paper account.

July 3, 2008 | Unregistered CommenterBC

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