Option Trading seems to be more popular now than ever before. We all know that options can help leverage the money that you trade or invest. But, for the beginning stock trader, the concept of options trading can be a little confusing. In this article, I will to talk about what options are and the different types of options. I will also show the advantage that the options trader could have over people who do not trade options.
Options can be broken down into two broad and general categories. There are call options and put options. The decision as to whether or not you want to use call or put options in your option trading depends on your opinion about where the market will go and how you want to make money based on that opinion.
One of the initial concepts that traders seem to find confusing is how options are priced. Usually, when people see the price of an option, it can be anywhere from a few cents to a couple of dollars. But, since a stock option represents 100 shares of the stock, the actual price that the trader will pay for an option has to be multiplied by 100. So, in option trading, a stock option that is priced at $.25 will actually cost $25 to purchase.
A call option is the right but not the obligation to purchase a specific stock at a certain price for specific duration of time. This allows a trader to purchase the right to buy 100 shares at the strike price of the option before the option expires. So, if you purchased an XYZ $50 call option that expires next month, you have purchase the right to buy 100 shares of XYZ stock at $50 before the option expires next month. These expiration cycles are normal to option trading.
Some traders don't see the advantages that others do in option trading until they do the math. Let's suppose you purchase the above option for $.50. Since you purchase the stock option for $.50 and have the right to buy the stock and $50, you need the stock to trade above $50.50 in order to make money. This is called your breakeven price.
Let's suppose that you check the stock price of XYZ stock and it's trading at $52. In order to calculate how much profit we would have on this trade at this price, you simply subtract the current stock price from the breakeven price. So, in this case you, would have profited $1.50. And, since options are traded in hundred share lots, this would translate to $150 profit. While this may not seem like a lot of money, keep in mind that in order to initiate this trade you only had to purchase the option for $50.
In the above scenario, the trader made money when the stock went up. Can we employ our option trading skills when the market goes down? You bet we can. If you are just looking to purchase options, this type of option trading strategy would employ put options.
A put option is the right but not the obligation to sell a stock to someone at a specific price before a definite period in time. So, traders speculating that a stock may go down would purchase a put option. Let's clarify this with an example.
Let's say that you expect that ABC stock will go down. With this in mind, you purchase the ABC $25 put option for $.75. Now, remember that the stock will need to be below our breakeven price in order for us to make money. In order to calculate the breakeven for this trade we would need to subtract $.75 from $25. So, once the stock begins trading below $24.25 you will be making money.
Option trading is not as confusing as some traders make it out to be. The concept of purchasing calls and puts are relatively straightforward and simple. As we have seen, the leverage potential and limited risk features found in trading options can be very attractive. For some traders, these are the two reasons that they get excited about stock option trading.
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