by Ian Harvey
The risks of options trading are limited to the price of the cost of the premium, which is an attractive benefit of trading options. By purchasing options, you can control a large number of shares at a fraction of the cost of actually purchasing those shares.
For example, if you bought options on a lot of 100 shares valued at $30.00 each, you might pay $1.50 per share. This would make your total investment $150.00 rather than the $3000.00 that you would need to invest to buy the shares.
To discuss the risks of options trading, let’s focus on call options. Call options increase in value when the underlying share price rises. However, they increase at a higher percentage rate than the price of the shares.
If the share value increases during the time of your contract you can make a profit. You can realize this profit either by exercising your options (buying the shares that you are entitled to buy at a lower-than-market-rate, and then selling them higher), or by selling the options at a higher price than what you paid for them. The limit to the profit you can make is only limited by the amount of movement in the market price of the underlying stock.
Since the risks of options trading are restricted to the cost of the options, regardless of how much the price of the underlying shares drops, you cannot lose more than the investment of the premium, which is a fraction of what you would have paid to purchase the shares. With the above example, if you bought the shares and then they dropped by 50% in value, you would be looking at a loss of $1500.00. This is 10 times more than the cost of the premium you would have paid if you bought the options.
While risk limitation is important to consider, of course the whole point of buying options is to make money. With this in mind, when you invest you will obviously do so in the expectation that the price of the shares will rise, and that your options will make a profit.
However, in speculative trading (investing based on your prediction of which way the market prices will go) there is always a chance that things will not go as you hope.
Knowing that the risks of options trading are limited to a much smaller investment than buying the equivalent number of shares, while at the same time the potential for profit is unlimited, helps to make trading options a very worthwhile investment choice.
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