The recent stock market crisis (2008) took the stock market down by more than 30% in less than a year. This has a lot of traders thinking that big money can be made simply by buying put options on stocks that will move down with the market, especially high beta ones. Nothing can be further from the truth. Most amateur options traders who did that either failed to make any money, make very little money or outright lose money even though the stock moved down a lot as predicted. Why is that so?

Volatile market conditions are especially bad for buying stock options due to 2 reasons. Firstly, the extreme volatility resulted in extremely high implied volatility which increases the extrinsic value of options dramatically, depressing its profitability. Secondly, extreme volatility leads to extreme speculation which encourages market makers to open up the bid ask spread to an unreasonably wide level in order to fill their own pockets.

Extrinsic value is the price one pays to the seller of stock options in order to justify the risk undertaken by the seller for giving such a right to the buyer. This price is arrived at in theory by options pricing models such as the Black-Scholes model. Extrinsic value directly affects the profitability of the options as the higher the extrinsic value of an option, the more the underlying stock needs to move in order to breakeven or profit. For example, if two options based on the same underlying stock, the same strike price and expiration month have different extrinsic values (of course this cannot be the case in reality), the option with the higher extrinsic value will make lesser money in profit than the option with the lower extrinsic value when the underlying stock moves by the same amount when held to expiration.

Extrinsic value is affected mainly by the level of implied volatility of the underlying stock. If the underlying stock is expected to make big moves, implied volatility goes up and the extrinsic values of its options go up as well. In times of extreme market volatility, extrinsic values go up dramatically across the board, depressing the profitability of options. In fact, one could end up losing more money than usual if the stock does not move according to expectations due to the higher extrinsic value paid. This is why a lot of amateur options traders who simply bought put options recently failed to make much money or any at all. This situation is made even worse by the wide bid ask spreads provided by the market makers.

Market makers are whom options traders really trade options with. When you buy an option, you are really buying directly from market makers who hold an inventory of those options and when you sell options, you are really selling back to these market makers who want to maintain an inventory of those options. Market makers buy and sell options in the exchange, ensuring the liquidity of all options contracts and profit primarily from the bid ask spread that they provide, buying at the bid and selling at the ask. They function exactly like used car dealers, buying at lower prices and selling at higher prices. Typically, the more actively traded the options are, the closer the bid ask spread tend to be due to competition between market makers, however, in times of extreme volatility where there are a lot more buying and selling on panic and more than enough business to go around for all market makers, they usually open up the bid ask spread in order to make even more profits. That is why we saw unusually wide bid ask spreads in this recent crisis. Wider bid ask spreads result in larger upfront losses which again depress the already depressed profitability of stock options due to the higher extrinsic values.

The higher extrinsic value and wider bid ask spread makes profiting from simple stock options buying extremely difficult and are the main reasons why amateur options traders fail to make money buying put options during the recent stock market crisis. Conversely, writing options are an extremely profitable way to trade options during a volatile market where extrinsic values are high. Naked writes and Credit Spreads are really the way to go in a volatile market condition and are what most beginner options traders do not know about. Selling options instead of buying them turns the table around and creates an extremely profitable position during times of high extrinsic value. Learn more about credit spreads at http://www.optiontradingpedia.com/free_debit_credit_spread.htm now.



By: Jason Ng

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There are four different types of players in the stock option trading game. They are buyers of calls, sellers of calls, buyers of puts, and seller of puts. The buyers are called holders, and the sellers are called writers. Buyers of calls are said to have a long position, while buyers of puts are said to have a short position.

Calls are useful in speculation, and puts are useful in hedging. It is all going to depend on the strike price of the underlying asset on the expiration date. If all of this makes perfect sense to you, there is not much need to read on, but if it sounds a bit hazy, a little review might be in order.

The Stock Option market has its own unique language. Like many other activities, an understanding of the terminology used is essential. In many cases, it is a rather simple concept hidden behind an unknown term that leads to confusion, and makes the activity appear a lot more complex than it actually is. The following are a few definitions that might help take away some of the mystery. - Calls: A call is basically a contract giving you an option, but not an obligation to purchase a block of stocks at a set price on or before a certain date. In understanding a call, it is important to remember that you are not obligated to make the purchase. You can exercise your option or not. - Puts: A put is the opposite of a call in that it is a contract to sell a block of stock at a set price on or before a certain date. Again, this is a choice. You can make the choice not to sell. - Holders: This is the name given to the buyers of the contracts. It is the holders that give the option trading market its name since they are the ones who actually are in a position to make the decision to exercise their options. - Writers: Since it is a “trading” market, two parties are necessary. If someone is buying, than someone else must be selling. The writers are the sellers of the contracts. It is important to remember that the writers are not the ones with the options. They do have an obligation to honor the contract if the holder decides to exercise his option. - Long Position: In stock trading, long position means that you are holding the stock in anticipation of it increasing in value. - Short Position: In stock trading, short position means that you are holding the stock in anticipation of it decreasing in value. - Underlying Asset: The underlying asset, or as it is sometimes called, the underlying, is the actual stock or security that is the object of the option contract. The contract is said to derive its value from the intrinsic value of the underlying asset. - Strike price: This is the price at which the option contract will be purchased or sold. If you purchase an option to buy, or make a call, at $10 , but the value of the underlying asset is only $8, you are $2 under the strike price, and most likely would not wish to exercise your option. - Speculation: This is the risk taking side of option trading. It is generally associated with calls and long positions. It essentially means that you are expecting a stock price to rise higher than the strike price. - Hedging: This is the cautious side of option trading. It is generally associated with puts and short positions. You are anticipating that the value of the underlying asset will drop below the strike price. It is called hedging because it is often used to protect an investment, or hedge your bet, by maintaining an option to sell at a certain strike price should the underlying asset take a serious drop in value. In other words, you are able to bail out before your loss becomes too large. - Expiration date: This is the date on which your option must be exercised or it will be lost. It is the deadline. In the stock option market it is usually the third Friday of a month.

The above are a few of the terms that are used in the stock option trading market, and by understanding them completely you should be better armed to take a closer look at this interesting investment opportunity.



By: Casey Yew

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