Home | Contact | Newsletter
Option trading provides many advantages over other investment vehicles. Leverage, limited risk, insurance, profiting in bear markets, each way betting or market going nowhere are only a few. But let's look at a couple:
One thing to note before we go on is that the buyer of an options contract pays an amount, known as the premium, to the option seller. An option seller is also known as the writer of the option. The option premium is simply the amount paid for the option - but there is more about this under the Pricing link.
When you buy an option contract from an option seller, you aren't actually buying anything - no asset is actually transferred until the buyer chooses to exercise. It is just an agreement where the buyer has the option to decide if the transfer is to take place. But the option contracts value is determined by the underlying asset - Microsoft Shares as an example.
Options give the buyer the right to buy a number of shares of the underlying instrument from the option seller. The amount of shares (or futures contracts) to buy is determined by;
The contract multiplier (also called contract size) is different for most classes of options and is determined by each exchange. In the US, the contract size for options on shares is 100.
This means that every 1 option contract gives buyer the right to buy 100 shares from the option seller.
So, if you buy 10 IBM option contracts, it means that you have the right to buy 1,000 IBM shares at expiration if the price is right (10 x 100).
Note: In other countries such as Australia, the contract multiplier for stock options is 1,000, which means the every option contract you buy entitles you to 1,000 underlying share contracts. So pay attention to the contract specs before you begin option trading.
This also means that the price of the option is also multiplied by the contract multiplier. For example, say in the above you purchased 10 options contracts that were quoted in the marketplace for 15c, then you would actually pay the seller $150.
This is a crucial concept to understand. If you go out and buy 5 IBM share options for 15c that have a Strike Price of $25, then you will;
In this case, your initial investment of $75 has given you $12,500 exposure in the underlying security.
Option trading is very attractive for the small investor as it gives him/her the opportunity to trade a very large exposure whilst only outlaying a small amount of capital.
Say you bought a $25 call option for $1 while the underlying shares were trading at $26. If the market rallies to $27 the option must at least be worth $2 because you can exercise your right at $25. So, even though the shares only went up 3.8% you DOUBLED your money because you can now sell back the option for $2.
Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it is for Microsoft to trade from $25 to $50!
For this reason penny stock trading is becoming very lucrative for online speculators. They can still trade the stocks outright as well as making massive returns if they are correct about their view on market direction.
The only drawback with penny stocks is trying to pick which stocks to buy. I'm not that familiar with trading penny stocks, however, I know of a great site that provides stock picks for penny stocks every two weeks - <penny stock affiliate link>. They have a free trial, so you can see for yourself whether penny stock trading is for you or not.
Penny stocks can be risky though - there's a reason why they're so cheap, nobody wants them! So, be careful to act on the right information.
One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless. Let me give you an illustration.
Remember our initial example of Peter buying a Microsoft Call option? Here are the details of that trade provided with the appropriate jargon;
Underlying: MSFT
Type: Call Option
Position: Long (i.e. bought the contract)
Strike Price: $25
Expiry Date: 25th May
At the time of the trade, Microsoft shares (the Underlying) were trading around $30. The Call option contract had been valued and was trading at $6.5 - known as the premium, but more on this under pricing.
So, from the above information we can conclude that after the 25th May, if Microsoft is trading above $31.50 we can make a profit on this.
Why $31.50? Because we paid $6.50 for the right to have this option in the form of a premium to the option seller. This means we must consider this in our profit estimate. Therefore we add the option premium to the strike price to determine our break even point.
If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise our right to Call the shares from the option seller. Then we will be assigned Microsoft shares at the exercise price of $25, which is the same as if we actually bought Microsoft shares for $25.
Note: If we exercise our right and take delivery of the shares, this means that we will have to pay the full amount for the shares. So, the number of option contracts bought multiplied by the contract size multiplied by the exercise price. If you are planning to hold onto option contracts until expiry and take delivery, make sure you have the cash!
But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares in your trading account with a purchase value of $25, yet they are trading at $40. So, you can sell them at $40 and make $8.50 per share.
Why $8.50? Remember the premium we paid? We have to consider that with our profit estimate.
Think about what happens as the underlying price continues to rise. You continue to make more and more money once the stock price has exceeded the strike price.
But what about the downside risk?
Let's imagine at expiration Microsoft shares are trading below our exercise price of $25 at, say, $20. Will we decide to exercise our right and take delivery of the shares and pay $25 per share? No way, because they're only worth $20.
So, we will just do nothing and let the option contract expire worthless.
What have we lost though? We lose the premium that we paid to the seller, which in this example was $6.5. That's it. A lot less than if the stock plummeted and we lost our entire investment.
What about if there is a stock market crash and Microsoft Shares are trading at $5 at the time of expiration? The same as if the shares are trading at $20 - nothing. We just let the option contract expire worthless and lose our premium - $6.5.
Can you see now how this type of strategy gives you the best of both worlds - both limiting your risk and at the same time leaving you open to make unlimited profit if the market rallies?
Not all option strategies have this payoff benefit. Only if you are buying options can you limit your risk. For option sellers, this is the reverse - they have unlimited risk with limited profit potential.
So, why would anybody want to sell options? Because options are a decaying asset, which you can read more about under the Time Decay section.
Another reason investors may use options is for portfolio insurance. Option contracts can give the risk averse investor a method to protect his/her downside risk in the event of a stock market crash.
One example of this is called a Protective Put. You can read more about option trading strategies under the Strategies link.
You could exercise, sure, but only if you want to continue being long the stock. If you just want to profit from the option you can sell it before it expires in the open market without having to take delivery of the stock.
Another question from the last example: If I chose Option (A) and on expiration day the stock has fallen to $4.00, should I now exercise the option to buy 100 shares for $2.5 and then immediately sell those 100 shares for $4 each? This way I make $150 from exercising the option which will help offset the money lost from the premium. So in the end, I only end up losing $75 ($225-150=75) from purchasing option (A).
Thanks and sorry if this is explained somewhere else and I overlooked it.
If the stock is trading at $11 at the expiration date then you have no buyers to sell to as the option will be worthless and you will still incur the $2 loss. If you don't have enough cash to exercise the option then you just lose the $2, however, in this case you would not exercise even if you did have the money because you would exercise to sell the stock at the strike of $10 when the stock is trading at $11 and lose an extra $1 on top of the $2 you have given away by buying the option.
Hope this makes sense.
Lets say I buy an option for a company A with a strike price of $10, the premium cost $2 and the current market price is at $11. On the expiration date, the market price is still at $11. If I let it expired, I will lose $2. What do I need to do to minimize the lost? Do I have to exercise the contract and sell back at the market price so the lost will only be $1? Can I sell back the option right on the expiration date? Is anyone will buy the option with the expiration date on the same day? What happen if on the expiration date I don't have enough money to exercise the contract? what is the best options for me to do?
Yes, the proceeds from the sale go back into your account. If the proceeds from the sale were more than what you spent on the option, then it is a profit.
Yep, you can get in and out of your position any time you like up until expiration. About your second question...it depends on the stock and how far out the expiration date of the option is...longer dated an option the less volume there will be. However, most optionable stocks have option market makers who are there to provide liquidity so you won't have a hard time getting out of a position...especially if it is close to the expiration date.
i have doubts on this: the premium we pay on the option contract ( in our example amount of $6.50) is considered to be valued for 100 shares or each premium price $6.50 will be summed times 100 shares = $650 ?
If I bought a call option contract on Dell with a strike of $20, today, and time to expiry of 120 days and the stock price is $9. Say after 40 days the stock price rises to $15 (still below strike), can I cash in on day 40? (i.e. sell back that call option)? If yes, does that hold for a put contract too?
That's right. You can trade in and out of options before expiration and take advantage of the leverage options provide, however, if you decide to exercise and take delivery of the underlying asset then you will need enough in your account to cover purchasing the stock.
If you exercise the option then you are assigned stock at a purchase price of $25 (the strike price). If the stock is trading at $31.50 and you sell the stock that you now own, then your profit is $6.50. But you've already spent $6.50 buying the option, so net you've broken even.
Make sense?
Yes, if you're long a call option that is in the money and allow it to expire, your broker will automatically exercise your option into shares provided you have the funds in your account.
You won't be able to exercise without sufficient funds available. If you wanted to profit from a call option right before expiration you would just sell back the contract in the option market to realize the profit.