Choosing a strategy is one of the most important things you will do as part of your business plan. There are, of course, many strategies and they include buying a stock, selling a stock short, buying options, selling options, writing covered calls, creating various spreads, and numerous other strategies.
One of your major considerations will be the risk you are willing to take when entering any given strategy. For example, if one buys a stock, the risk is quite high. The risk in buying a stock is the price of the stock. While it is unusual, a stock can go to zero so it is a risk of the total amount paid for the stock. On the other hand, if one were to purchase a call option the risk would be much less than the price of the stock since the call option is cheaper than the stock price. However, when buying a call option one must be aware that the option is going to expire. So an additional risk when buying any option is the fact that time is running against the buyer.
Each individual trader needs to do a little self analysis to determine what strategy is most comfortable for them. Many traders choose to simply buy stock since that is the strategy with which they are most familiar. In doing so, the trader needs to be aware that such a strategy often requires a relatively large amount of money. Even if stock is purchased on margin the trader will have to initially supply half of the price of the trade plus the commission. In the event that the stock goes against the trader he or she will suffer a dollar for dollar loss.
Unlike just buying a stock, when buying a call option the trader usually is going to spend much less money because the call option will be cheaper than the stock price. The buyer of a call should be aware of the delta of the call. The delta is a measurement of how much an option is expected to move with a dollar movement of the price of the stock. In other words, if the delta is .5 that means that the price of the option is expected to move 50 cents for every dollar the stock moves. Frequently, at the money calls have a delta around .5. As the stock moves up the delta generally will increase. Conversely, as a stock moves down the delta of a call option can be expected to lessen. Therefore, buying a call option will provide greater leverage to the trader than buying the stock itself. However, when buying the stock itself the delta will always be 1. In other words, the stock makes or loses a dollar for every dollar the stock moves. The trader should be aware of these phenomena when selecting strategies to use in their own business plan.
In the future, I expect to address several strategies and some of the strengths and weaknesses of each.
Good Trading!
Bill Kraft
Mr. Kraft's past articles are posted on our website for your review.
-- by the Dividend Investor Team
