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The Four Building Blocks of Stock Option Trading Mastery

By: Billy Williams..
 

In today's investment environment there are numerous investment strategies and instruments to trade or invest in but few have the power, leverage, and ability to control risk than stock option trading. In today's markets, online option trading has allowed the common investor or aspiring option trader to have access to this powerful asset class as easily as the veteran trader on Wall Street. Sadly, some would be option traders are intimidated by the seeming complexity of derivatives and avoid them. However, by devoting study to four basic option strategies the aspiring trader can begin to harness their enormous potential and gain mastery over stock option trading formulas. The four option strategies are call position, the short call position, the long put position, and the short put position.

A call option, or long call option strategy, is a bullish strategy that a option trader uses when he sees an upward bias in a company's stock. One call option allows you to control up to 100 shares of the company's stock and your reward potential is theoretically unlimited. His risk is limited to the price of the call option he purchased though however an option trader must factor time into his investment decision because time decay works against his position as the expiration date for his call option approaches.

The short call is easy to execute but is a risky strategy given the risk to reward profile which makes this somewhat of an advanced stock option strategy. The strategy is used if you believe that a stock is going to decline or stay at the present value. You implement the strategy by allowing someone to sell a call option to you. Your reward is the value of the premium at the time the call option is sold to you. This lets the seller of the option assign his risk to you while hedging his position. Time decay works for you as you approach the expiration date for the option you stand to gain more of the premium at assignment. The short call exposes you to uncapped risk if the stock rockets higher in price value and most brokers will not allow you to trade this strategy unless you are very experienced with stock option trading or hold a position in the stock that you are trading this strategy on.

The long put strategy is the inverse of the long call strategy where you are looking for the stock to decline rather than rally. When you buy a put option you control 100 shares of stock in a company and lets you take advantage of enormous leverage. Your reward potential is theoretically unlimited while your risk is limited to the cost of the put option. You must be sure to give yourself enough time to profit with your trading method because time decay works against you with this strategy.

The short put strategy, also called the naked put strategy, is used when you are expecting a stock to rise in price or remain at near the same price level for a given amount of time. Your reward is the cost of the put option if the stock rises or remains static but your risk is theoretically unlimited if the stock declines. If it falls in price and hits your stop loss point you must buy back the puts to limit your risk. This is a bullish strategy that is a short term income generator when used properly.

By taking the time to understand how each of these strategies work in a variety of market conditions you will begin to gain the foundation to master implementing them in combination. These incredibly effective risk reducing, profit enhancing instruments allow for over 60 different stock option trading strategies but all these combinations begin with these basic four strategies. As you gain mastery over how to coordinate them you will be able to put yourself in the best position to profit while maintaining the ability to limite your risk. Good trading.

Article Source: Main Articles

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