There has been a gradual increase in the use of stock options by investors and traders to maximize their returns and leverage over the past few years. This rise in option trading is due to the high returns they provide over individual stock trading. The liquidity rate has also increased steadily due to increased trading activity and more concentration of funds in such derivative instruments. Today stock option trading is considered to be profitable business if done with proper knowledge and application of basic principles of technical analysis.
Stock option trading enables investors to increase their leverage and thus their rate of return over simple stock trading. If an investor has an expert knowledge on picking stocks that go up in the short term, the returns can be increased by 10 to 15 times using stock options. The trade off for this increased return is that the investor has to also take into account the time period over which the increase will occur.
Successful stock option trading requires complete dedication on the part of individual trader or investor. He should be able to pick a suitable stock and judge its direction over a given period of time. A recent statistical analysis of over 25 years of stock data has revealed certain reoccurring patterns that can yield high returns in stock option trading. The analysis was done with custom developed software and then the strategy was applied to all stocks for the last five years. Stock trading resulted in an average return per trade of 3.2%, but with stock option trading the average return per trade was over 55% for the current period.
Investors and traders have already begun to exploit the patterns found in this research and are reporting highly profitable trades. Whenever investors find inefficiencies in the market, there is a rush to take advantage of those inefficiencies.
Although stock options are not available on all stocks, about half of the stocks found in the analysis did have tradable options. If the trend of increasing use of stock options by investors continues, we should see even more addition of stock options for investors. It is easy to see that 70 to 80 percent of actively traded stocks will have option contracts available in the forthcoming period if this trend continues.
A decision to buy a particular stock option contract depends entirely on the volume and open interest of that specific option, so investors should first take a look at these important indicators before buying any option contract. A low volume/open interest will generally result in large spreads between the bid/ask prices and thus reduce profits, plus it may make it difficult to sell the option contract.
Volatility is another consideration that should be taken into account before selecting an option contract. Stocks with high price swings will translate to more expensive options since the options will have a greater likelihood of being in the money. If you have a reliable method of forecasting stock movement, this higher price may not be a consideration.
Written by M Banker2010