LEARNING TO TRADE OPTIONS

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TRADING OPTIONS: A LITTLE BIT OF SOPHISTICATION
The stock market is not only about making money. For many investors it is also a way of preserving capital, especially during periods of rapid inflation.
The vast majority of investors buy stocks -- either individual stocks or mutual funds or ETFs (exchange traded funds) -- and not having any realistic alternatives -- hold onto their investments for decades. More sophisticated investors practice diversification and asset allocation techniques by:
·          Selling some stock when prices have increased by so much that the investor is over-invested in stocks and under-invested in other asset types.
·         Buying additional stock when prices have undergone a significant decline and the investor is under-invested in stocks. The needed cash comes from selling the part of the portfolio in which he/she is over-invested.
STOCK OPTIONS
There are other methods and tools that investors can use to reduce the possibility of losing money from any specific investment. That reduced-loss situation is another way of preserving one's assets.
And the tool of choice to accomplish that objective is the stock option.
The problem with options is that too many individual investors learned to fear options and never bothered to learn how they work. Each of the following gives option trading a bad name, but these do not apply to you:
·         A handful of rogue traders have gambled with money that was not their own and caused irreparable damage. News coverage emphasized that these traders used options or other derivatives in their trading and helped spread negative opinions regarding options trading. Examples: Barings Bank.

USE OPTIONS TO EARN PROFITS MORE OFTEN

OPTIONS ARE YOUR FRIENDS
Investing vs. Trading
Traders tend to ignore the nature of the business and rely only on their ability to predict short-term price movements.
Investing is different. It is based on your ability to understand the basic financial condition of the company, compare it with its peers and make a good evaluation of how well-poised this company is for the future. That's research. When you find a business that is worthy of making an investment, you buy shares and wait for your good judgment to pay off. But you do not wait idly. Investing requires periodic re-evaluation of your holdings because the world changes and you do not want to be married to a poor investment.
Option Traders
Option traders are not investors.
Nor are they very short-term traders. The option markets, with their wide bid-ask spreads, are not designed for day traders.
·         Option buyers require that the stock make a move -- in the right direction -- in a relatively short period of time.
·         Option sellers require time to pass and for the options to decay without the stock moving in the wrong direction.
Option traders also have built-in risk-measuring tools (the Greeks) that make it more efficient to use options than stock. The Greeks include Theta (the risk of holding as time passes), Vega (the risk of holding a position as implied volatility changes) and Delta (the risk of being too long as the market falls; or too short as the market rallies). These Greeks allow traders to get a good estimate of how much money is at risk -- as well as the potential reward -- that comes with their market prediction.
Why is this important?  Too many traders ignore the following question:  
Why do I believe that I can correctly predict which stocks are moving higher or lower?
Even when traders lack proof of any ability to correctly predict direction, they still take bullish and bearish positions with a high expectation of making money. That is not reasonable. 
Predicting direction is difficult. Most professional money managers cannot consistently beat the market averages. And they are paid big bucks for that inability. Instead of trying to do what they cannot do, why not trade with a much improved chance of success? Options allow you to do just that.

EQUIVALENT POSITIONS

Puts and calls are obviously different option types. However, there is a mathematical relationship between calls and puts when the put and call expire at the same time, have the same strike price, and are on the same underlying asset.
Because of that relationship, there is more than one way to build any option position -- and that means that there are equivalent positions (i.e., positions with identical profit/loss profiles) -- even though the positions appear to be very different. 
Although you can survive by avoiding the small amount of homework involved in understanding this concept, but it does mean that you will occasionally be leaving money of the table for no good reason. Isn't that why you are trading? To make money?
Traders own positions with an expectation of earning a profit when the markets behave. If you can own a different position that results in the same profit (or loss), but which requires paying less in commissions, wouldn't that be preferable?
Infrequently you may discover that the markets are temporarily inefficient (it won't last long), and that one of the equivalent positions is available at a slightly better (perhaps $0.05) price than its equivalent. If you spot that difference, you can own the position with that $0.05 discount. 
The basic equation is often referred to as put-call parity. You can find more details here.  For the purpose of introducing this topic, the effect of interest rates is ignored. 
Put-call parity describes the relationship between calls, puts, and the underlying asset.
Owning one call option and selling one put option on the same underlying asset (with the same strike price and expiration date) is equivalent to owning 100 shares of stock. Thus,
S = C – P
Where S = 100 shares of stock;   C = one call option ;   P = one put option
Simple proof:  Consider a position with one long call and one short put. When expiration arrives, if the call option is in the money, you will exercise the call and own 100 shares. If the put option is in the
money, your account will be assigned an exercise notice and you must buy 100 shares. In either case, you own stock.
NOTE: If the stock is exactly at the money when expiration arrives, you are in a quandary. You don’t know whether the put owner will exercise and therefore, you do not know what to do with your call. The best solution is to buy the put to cancel any obligations. It should not cost more than $0.05. Next, if you do want to own stock, exercise the call option. If not, allow the call to expire worthless. By covering the short put, you are in control.