Friday, July 4, 2008

Option selling

One of the most powerful ways of trading is option selling. This is a way that you can make money without having to predict the direction that the market is heading.

The reason for this is that when you sell options you instantly make money. The bad part is you will have the liability of buying or selling the stock at a given price if you are wrong. But if it does not get to or pass that level you can keep the profits and cash out positive.

There are two different ways you can sell options

1. Selling naked options. This is when you just sell an option. You hope that it does not come down to the level of the option by expiration. The danger of this is that you have an unlimited risk with a limited reward.

If sell a put for the $50 strike price for $1 you have to buy it at $50 if it goes lower than that. And if the market crashes you will have the ability to lose up to $50. So this is the most dangerous type of option selling with huge risks.

2. Credit spreads. This is different than naked puts because you do not have as big of a risk. An example of this would be if you not only sold the $50 call for $1 but bought the $45 call for $.5. You would make the difference between the amount you sold the $50 put for and the amount you bought the $45 put for or $.5. This limits your possible gain.

The benefit of this is that it also limits your maximum loss. Because you have the right to buy the stock at $45 your maximum loss is only $5. This is true no matter how far the stock may fall. This alternative produces a lower reward but also give less of a risk which might be worth it.

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