Options Trading Explained

Benefit From Trading Options!

submitted by “Options Trading”

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October 16, 2012

Introduction

Options trading is an extremely popular way of investing into the financial markets, especially in the USA where it first developed into its current form. The most traded options market is stock options which is an alternative to buying shares outright that comes with many benefits.

How does it work?

When you trade an options you are purchasing the right to buy (or sell) 100 shares of an underlying asset at a fixed price, within a set period of time. It is called an “option” because you are not obligated to complete on the trade, if you choose to, you can let the options expire but you will lose the initial premium you paid for opening the contract.

A simple example:

Company ABC is currently $100 a share. If you think the price is going to go up in value over the medium term, you could buy a six month call option. Just say the price of this is $104 - you are essentially paying the broker $400 for the right, but not the obligation to purchase 100 of these shares at any point within the next six months. If the price increased by 10% to $110, you could exercise your option and make a profit of $6 on every share. If the price dropped by 10% to $90, you would simply let the option expire where a $4 loss would be incurred.

The great thing about using options is that the upside to gains is unlimited while the most you can ever lose is the premium you pay when buying.

Benefits

There are a number of key benefits to trading options over more traditional forms of investing:

You can go short as well as long. There are two different types of options: the “call” and the “put”.

• You will buy a call option if you think the price of an underlying asset is going to increase as it will allow you to purchase stock at a pre-determined price meaning you can sell it back to the market at a profit - if the price does in fact increase.

• A put option works the other way, it gives you the right to SELL a number of shares of an underlying asset and you would trade a put if you think the price is going to fall.

Leverage and Margin

Stock option leverage allows the buyer to trade contracts for a small percentage of their actual worth. This allows the trader to potentially make much higher profits with smaller initial sums of money. Anyone that is interested in getting started with trading options must also realize that this leverage can also cause larger losses if the market were to go against you.

The margin required when trading will vary from broker to broker and from market to market. It will depend upon the risk appetite of the broker and how much risk there is perceived to be in the underlying asset.

Summary

Although trading options is a viable alternative to purchasing stock for many people, it isn’t for the faint hearted. Large sums of money can be made and lost due to the margin that brokers allow their clients. It does however carry many benefits, limited losses and unlimited gains probably being the biggest although many people would argue that the leverage at their disposal is more attractive.


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