Simply put, options are contracts that give the buyer the right to buy or sell a stock at a future date for a set price. Traders use options to get in or out of a position quickly and as a way to protect their investments. Once a niche pocket of the investing world, options trading is growing at a 40% pace, according to the New York Stock Exchange.
But the options pits can be a confusing maze of “puts” and “calls” to the average investor. Pete Najarian, a veteran options trader, explained the ins and outs of the market and some of the ways he trades.
Cover call writing
Cover call writing involves a call option sold (or "written") against a holding of the underlying shares. If you hold a number of shares and feel that the short-term price outlook of the share price is weak – but you don’t want to sell the shares in hopes that they could go higher – you could gain additional income on your share holdings by writing a covered call.
This is the most popular way to use options, according to Pete. When he’s long a stock there is a very good chance he has sold an upside call.
Bull Call Spread
This trade is used when an investors expects a moderate rise in the price of the underlying asset. It is achieved by purchasing call options at a specific strike price while also selling the same number of calls of the same asset and expiration date but at a higher strike.
The key to this trade, said Pete, is instead of just buying the call you must also go outside and sell the next higher call and use that money to finance the purchase of the lower priced option.
Bear Put Spread
Used when an option trader expects a decline in the price of the underlying asset, a bear put spread is achieved by purchasing put options at a specific strike price while also selling the same number of puts at a lower strike price. The same principles used in the bull call spread apply.
> The Traders’ Styles
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Trader disclosure: On Feb.12, 2008, the day of taping, the following stocks and commodities mentioned or intended to be mentioned on CNBC’s Fast Money were owned by the Fast Money traders; Macke Owns (INTC), (YHOO), (DIS); Najarian Owns (BIIB), (C), (CSCO), (MCD), (MS), (MSFT), (YHOO), (XLF); Najarian Owns (AAPL) Calls; Najarian Owns (FRE) Puts; Finerman Owns (GS); Finerman's Firm Owns (AAPL), (GE), (MSFT), (WMT), (YHOO); Finerman's Firm And Finerman Own (HD); Finerman's Firm Is Short (SPY), (IJR), (IYR), (MDY), (IWM); Finerman's Firm Is Short (LEH) And Owns (LEH) Puts; Seymour Is Short (VIP) Puts