Stock options are traded widely by every category of trader and investor, both professional and non-professional. In addition to pure speculation, options are used to hedge risk, employing a variety of trading strategies. Fund mangers, banks, financial institutions, and others, use options to hedge risk, providing a form of insurance as protection against reversals that can occur without warning in financial affairs. Hedging is a very important use of options.
The advantage is leverage, lesser capital for equal gain
For the small trader wishing to speculate, perhaps someone who is already trading stocks, the main advantage that options have over stocks is that a lesser amount of working capital is needed for trading options. And yet the potential profit is actually much greater for the option in terms of percentage than the amount of profit produced by the stock for a price change of the stock to which the option is related.
The cost of an option that covers 100 shares of a specific stock costs only a fraction of the cost of 100 shares of that stock. A high-priced stock usually has options available ranging from several cents to just a few dollars. If the underlying stock’s price does move in the expected direction in the time that the option is in force, the option benefits by the price gain in dollars can be as much, or almost as much, as the more expensive stock. The end result being that the percentage gain on the option is many times the percentage gain on the stock.
The disadvantage is higher risk
Stock options are time sensitive, they are valid for only a specific and limited amount of time after purchase. For this reason, the risks in trading options are greater because they are a wasting asset in part of their value, referred to as “time value”, that decreases as each day passes. If the expected move in their underlying stock does not occur, which is the reason for their purchase, the option continues to decline in value until it expires worthless, leaving the option trader out of pocket by the amount paid for the option.
Limited loss, a negative and a plus
That negative aspect of a losing option trade, limited to the amount paid in the original option purchase, permits the trader to set the amount of capital to risk when making the trade, negative but a form of risk management.
Types of options
Options are available that provide either the right to buy or the right to sell. Such options are called Calls for the right to buy and Puts for the right to sell.
A call stock option is a contract that gives the owner of the option the right to buy 100 shares of a company any time until a specified date for a specified price.
The put option definition is much the same except specifying the conditions to sell.
A put stock option is a contract that gives the owner of the option the right to sell 100 shares of a company any time until a specified date for a specified price.
The three elements specified in an option contract:
- the underlying asset, 100 shares of the stock of the specified company
- the expiration date when the option expires and after which it no longer exists.
- the strike price, also called the settlement price or the exercise price. The strike price is the exact price at which the option can be exercised as long as it is still within the term specified by the expiration date.
Trading options requires an acquired skill and an understanding of how stocks perform in the market place. It requires knowledge of how to identify stocks that are ready to move in price when they have broken out of the restraints of a resistance or support level. And there are often discernible patterns of activity in the price changes and trading volumes of a company’s stock from which such information can be deduced, and also perhaps, the possible extent and duration of a new trend in the changing price levels of the stock.
For more information and some guidelines for trading options, check out these links:
Rules for Trading Options and also Trading Stocks and Options.
