Trading Stock Options

By www.ProfitableTradingTips.com
Trading Stock Options

http://profitabletradingtips.com/trading-
investing/trading-stock-options
Trading stock options holds two definite
advantages over trading stocks directly.

A smart trader can certainly make
money trading stocks.

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But by trading stock options the same
trader can limit risk and leverage his
trading capital.

What Are Options?

Options are contracts that give their
buyers the right, not the obligation, to
sell or purchase the underlying assets
at a future date, within the term of the
contract.

Whether it is in stock options trading or
in trading commodities like corn
futures, trading options allows the
investor to invest trading capital using a
variety of strategies.

A call option gives the buyer the right to
buy and a put option gives the buyer
the right to sell the underlying stock.

Sellers are paid a premium for taking
on the risk of having to buy or sell at a
loss when the buyer chooses to
execute his contract.

Options are used to both hedge risk
and to leverage trading capital.

Hedging Risk and
Leveraging Capital

In trading stock options a buyer limits
his risk to the premium paid.

Let us say that your fundamental and
technical analysis of ABC stock
indicates that it will soon rise in price.

You can buy a hundred share of ABC
for $100 a share or $10,000. Or you
may see that you can buy a $102
option on ABC for $1.

A $102 option means that you can buy
to stock for $102 a share at any time up
until the end of the contract.

Obviously the stock is currently worth
$100 a share and you would not want
to execute the contract.

But, if your analysis is correct the stock
price will go up.

Let us say that the stock goes up to
$110 a share.

If you purchased the stock you make
$1000 minus fees and commissions.

That is a ten percent return on
investment. And if the stock price falls
to $90 a share you lose $1000, ten
percent of your trading capital.

But in trading stock options on ABC you
pay $100 for a $102 call option on 100
shares.

The stock goes up to $110.

You execute the contract and purchase
the stock for $102 a share and then sell
for $110 a share.

You make $8 a share or $800 which is
a $700 profit or 700% return on
invested capital.

And, if the stock price falls to $90 you
lose your initial $100 and no more.

Short and Long Term

Trading stock options is not just for
short term profits.

Let us say that you have purchased a
hot growth stock.

It has multiplied in value but you are
afraid that it is ready for a correction
and you do not want to lose twenty or
thirty percent of your gains.

You also believe that the stock as a lot
more growth potential so you do not
want to simply sell, take your gains and
walk away.

In this case you can buy puts on the
stock that you own.

This gives you the right to sell at the
contract price no matter how far the
stock might fall in price.

In the case of ABC, if you purchased a
$98 put when the stock was $100 and it
fell to $90 you could still sell at $98 and
then turn around and buy again when
the stock bottomed out.

Trading Stock Options

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