Explaination Option Trading

It's not like you can go down the street and ask your neighbor to explain option trading to you. They may understand stocks or mutual funds, but few people understand options trading.

The so called "gurus" will gladly explain it to you, if you pay them thousands of dollars up front. My experience tells me that the options trading community is a very tight lipped community with a high price of admission. This is why few people ever learn how to trade, or know about stock options trading.

I have to tell you that yes, I did pay that kind of money to learn how to trade and yes, it was worth it, but my opinion still remains the same about learning. You shouldn't have to pay for the basics!

In this lesson I'll not only explain option trading, but also show you how profitable it can be.

Option Trading

The first way I'd like to explain option trading is in terms of what I do on a day to day basis. I'm an option trader and I trade stock options. As an option trader I'm essentially in the business of buying and selling contracts.

"Real estate investors" buy and sell homes. "Option traders" buy and sell contracts.

The contracts are stock option contracts, but don't be too concerned with the type of contracts. Just remember this simple definition: Options Trading is the business of buying and selling contracts.

Contracts? Yes contracts. You know, like the contract you sign to buy a house, or a contract you have with a lawyer or musician.

Contract: an agreement made between two or more parties.

I could explain option trading with the dictionary definitions of stock options, and options trading, but that would bore you. Besides, I'm sure you didn't come here for that. You most likely came here for someone to explain option trading in an easy-to-understand manner.

Now bear with me for a moment as I explain option trading in a way that has nothing to do with the stock market. This will help some people understand how buying and selling contracts can be so profitable.

Options Trading Example
Let's say you find an undeveloped piece of land that you believe will increase in value over the next few years. You don't want to buy it outright, but you would like to tie up the land with a contract that gives you the right to buy the land if you so choose to.

The land is in the middle of nowhere, surrounded by 20 miles of forest on each side. You have it appraised and find out it's worth $25,000. You approach the owner and ask him/her can they draw up a contract with a time period of 3 years that will allow you the right to buy the land any time during those 3 years for a set price of $25,000.

Remember this is what the land is worth right now. There's nothing around it and its just boring, raw, undeveloped land. You pay him $2,000 for the rights of this contract.

You're not obligated to buy the land, you've just purchased the right to buy it. If you decide not to purchase the land your contract will expire, and you'll lose your $2,000.

You Hit the Jackpot!
Time goes by and two years later the city has built a new mall 15 few miles down the road. New housing developments have gone up and to top it off Wal-mart builds a super center right next to the lot that you have the contract for. This is now a prime real estate location.

Remember you have the right but not the obligation to purchase that lot next door for $25,000 AND you only paid $2,000 for the contract.

Now let's use a bit of common sense. Two years ago the land was only worth $25,000 because nothing was built around it. Do you think the land is worth more now that there are malls, housing developments, and Wal-mart next door?

Yeah, you bet your bottom that lot is worth more than $25,000. For exaggeration purposes lets say the lot is now worth $100,000. You're a happy camper! You own a contract that says you get to buy that land for only $25,000. So if you wanted the land you could exercise your contract and purchase the land for $25,000.

You would then be the proud owner of a $100,000 piece of real estate that only cost you $25,000. You could keep it, or sell it on the open market and pocket the difference between what you sold it for and what you paid for it ($73,000 or 270% return on investment).

Or you have another option. You could take the approach of an option trader. You could take that contract and sell it to someone else.

Remember you paid $2,000 for the contract. You now own a contract that says you have the right to buy a $100,000 piece of land for only $25,000. Do you think someone might be willing to pay you more than $2,000 to own that contract?

Yes any person in their right mind would.

Time to Make Some Money
You decide that you don't want to own land and you'd rather sell your contract to someone else. You sell your contract to a local land developer for $20,000 and you walk away happy because you just made an easy $18,000 dollars or a 900% return on your money.

So now you have an example of how buying and selling a contract can be profitable. It's also probably one of the easiest ways to explain option trading because as an option trader, buying and selling contracts is what you'll be doing.

**Tip** Do not dig deeper into the example. A lot of people try to figure out why a person would let someone tie up their land. Others want to know why the person who bought the contract didn't just buy the land. Keep your thinking on the surface level. Buying a contract and selling it at a higher price.

Here's the lesson: As a stock option trader you're going to invest a relatively small sum of money to buy a "contract" that controls something larger. Your research tells you that your contract will increase in value before a certain date. When it does increase in value, you're going to sell the contract for a higher price than you paid for it and pocket the difference.

Profitable ETF Trading Strategies

If you are a trader that uses technical analysis, or if you are just considering applying some technical techniques to enhance your investing and trading strategies, my recommendation is make sure you start with just a few tools, and understand them thoroughly, rather than flit about from tool to tool like a bee investigating flowers.

The reason for this is that most technical indicators derive from price, and thus have a lot more in common than may be immediately apparent. If you only examine them superficially, at wave top level, instead of diving deep, chances are you will not get the full value of the insights that even the simplest ones can reliably provide.

You are also more likely to have a partial understanding of many tools and when you put them together you may think you have more information about the market than you really have and may then act with more confidence than is warranted. In the case of technical analysis it is especially true that a little knowledge is very dangerous.

There are some broad categories of technical tools available to describe various dimensions of market conditions. Two of the most important are: measures of trendingness and oscillators

Measures of strength of trend: because the market seems to have different performance characteristics when the market is trending, it is useful to have an indicator that indicates when the market or the asset trend is sufficiently strong to begin specializing in trend following strategies.

These strategies include making an entry with a wide enough stop to allow the trend to fully develop, but close enough that a true change in trend will allow you to exit the position with a percentage of profits intact. In trends that are very strong, the strategy of buying on dips can definitely improve your returns.

Oscillators define periods of Overbought and Oversold, and are especially useful when the market is not trending up or down but can be considered to be in a band or a sideways trend. Authors disagree on what percentage of the time markets are found in this condition, and it is clear by visual inspection that some markets are trendier than others.

However, all generally agree that the markets spend enough time in sideways conditions (or non-trending conditions) that having strategies optimized for these conditions can give you a significant edge.

For example, in a sideways market, with prices confined to a definable channel, you are looking to buy low in the channel and harvest near the top of the channel. If the market were trending though you would be inclined to buy near the top of a channel, anticipating a powerful breakout from resistance which would sweep you along to new profits.

Forex Leverage Regulation

The retail forex market has long had significant leveraging allowances, but this has recently come under threat by FINRA, the largest independent securities regulator in the United States.

Since the Internet retail forex boom, many forex brokers have been offering their clients anywhere from 50/1 to 400/1 leverage on their accounts. FINRA is claiming that the proposed change would serve to protect investors from excessive market risk.

This proposal, however, assumes that traders are not using leverage properly. Having leveraging capabilities isn't tantamount to over-leveraging one's positions, and this is what the FINRA proposal is failing to recognize; instead, leverage merely allows a trader to exercise exact risk management in relation to the size of their positions.

For instance, if a trader wished to risk only 1% of their total capital per position, they would use leverage to determine the amount that they are willing to risk per pip, based on the size of thier stop loss.

Having leveraging capabilities allows a trader to dynamically adjust the size of their stop, so as to accommodate the current volatility levels of the market, while still maintaining a fixed position risk, regardless of whether they are risking 10 pips or 1000 pips.

Conversely, not having such leverage available will likely negatively impact traders who are using appropriate risk management. Reducing the leverage means that you will have less available margin for active positions, even if you are risking the same amount in both scenarios.

This means that such traders are more likely to experience a margin call, assuming a consistent position risk, if the leveraging allowances were to be reduced.

The most unpalatable part is that FINRA not only wants to limit the leverage - they evidently intend to practically eliminate it. If FINRA simply wanted to bring forex leveraging limits to the levels of commodity futures it would be far more understandable.

Under the proposal, however, forex brokers would only be able to offer leverage of 1.5:1. Anyone who trades the forex markets knows that this would effectively put an end to US-based retail forex trading, since very few people would be able to properly trade under such a mandate. US-based FCMs would go out of business, and US-based traders would invest their money with oversees brokers.

The FINRA proposal sadly appeals to the lowest common denominator: the people who over-leverage positions with inappropriate stop-losses. In doing so, they consequently hurt all of the traders who trade with appropriate risk management, and merely use leverage as a necessary and responsible tool.

For anyone that is worried about this, you can rest easy for the moment. As it thankfully turns out, FINRA does not have specific regulatory authority over the forex markets; that would increasingly be the domain of both the NFA and the CFTA, whose regulatory capacity is significantly expanding in forex.

Further, it wouldn't be in the interests of the NFA and CFTA to support this proposal, not to mention the flagrant inconsistency it would create with currency futures: they have been working long and hard to exact more control over the domestic forex market.

If it were to predominately move oversees, they would have lost the ability to effectively regulate such activities (not to mention the membership fee revenue that they would receive from Forex CTAs).