What is options trading?
For many stock traders, options trading is still shrouded in mist. They consider it to be a very dangerous form of trading which should be avoided at all costs. Nothing could be further from the truth: once a trader knows what he or she is doing, options trading could in fact be as lucrative as stock trading and more – with a lower degree of risk and a higher degree of flexibility.
An option is the right, but not the obligation to buy a specific share, currency, commodity or futures contract at the agreed price at a certain future date. A trader can, for example, purchase an option which gives them the right to buy 100 shares of Company X at a certain price (called the strike price) three months from now.
Benefits of options trading
To buy 100 shares of Company X outright could cost a trader a few thousand dollars. Because options are leveraged, however, he or she can buy an option at a much lower price. This could be as low as 1% of the actual stock price.
But apart from that, how will options trading benefit a stock trader compared to buying the actual share? This part is quite easy. Let’s assume this trader purchased an option to buy 100 shares of Company X for $21 three months from now.
If the share price should rise to $26 by that time, the trader will get the full benefit of the price movement, i.e. $5 x 100 shares = $500 – without actually ever owning the stock. Remember there is no obligation to exercise the option: at expiry the option price will reflect the price increase of the share, so a full profit will be made.
If the price of Company X shares should close below the strike price of $21 three months from now, even if it drops to $10, the options trader can never lose more than the amount initially paid for the option.
Calls and Puts
The example we quoted above is that of a so-called call option. Someone should buy one of these if they expect the price of the underlying asset (share, commodity etc.) to go up between now and the expiry date.
But the incredible flexibility of options trading also allows a trader to benefit when the price of the underlying asset goes down. This is called a put option. Don’t let it become confusing – it works in exactly the same way as a call option, except that the trader will benefit if the asset price moves below the strike price.
As with call options, when someone buys a put option, he or she can never lose more than the initial price that was paid for the option. This is called the premium of the option.
Profit and loss scenarios
A picture is often worth a thousand words they say. Below are the profit and loss scenarios if a trader buys call or put options. Note the limited loss if the price doesn’t go where it is expected to go and the unlimited profit if it does.
Options trading can become much more involved than the examples given above, but once the trader understand the basics the learning curve is not so steep. There are even option trading strategies to benefit from a completely stagnant market, but more about that later.