Trading Stock Options
Trading stock options holds two definite advantages over trading stocks directly. A smart trader can certainly make money trading stocks. 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