Why Trade Options?
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:
Leverage
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 number of option contracts, multiplied by
- The contract multiplier
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;
- Pay the option seller $75
- If you decide to exercise your right and buy the shares, you will have to buy 500 (5 x 100) (100 being the contract size) shares at the exercise price of $25, which will cost you $12,500.
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.
Limited Risk
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 option pricing models.
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.
A profitable trade
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?
A losing trade
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.
Limited Risk AND Unlimited Profit Potential
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.
Insurance
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.
58 Comments
Peter April 26th, 2009 at 6:51pm
Hi Dan,
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.
dan April 25th, 2009 at 1:23pm
I have an call option on a stock thats 20 @ share. the stock goes to 30@share. I sell the option and the difference in price is put in to my account? Is that correct?
Peter March 25th, 2009 at 4:52am
Hi Doug,
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.
Doug March 24th, 2009 at 3:35pm
Hello I have a couple questions. Lets say buy a call option for $1 and the stock is trading at $21 at that time. Right before the expiration date the stock is trading at $30. I want to take advantage of this gain but I don't have enough money to pay $2100. Can I just sell the option before the expiration date? And if I can, I see there isn't much volume in options so is it easy to get in and out like high volume stocks?
Admin March 24th, 2009 at 4:00am
The price is quoted in the market at $6.50. However, each contract represents 100 shares of the underlying asset. When the trade actually takes place each 1 unit you purchase will actually cost you $650.
framonf March 23rd, 2009 at 10:55am
Hello Admin,
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 ?
Admin March 16th, 2009 at 5:33am
Yep, you can sell back at any time provided there is a market there - i.e another buyer to sell to. You may not necessarily "cash in" as the price of the option at day 40 may be less than your original purchase price.
Mike March 10th, 2009 at 1:49pm
Sorry if this was asked before but am I right?
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?
Admin March 5th, 2009 at 3:37am
Hi Paul,
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.
Paul J Snyder March 1st, 2009 at 6:22pm
I have never traded options but would like to start. My question is this. If you purchase on option and decide to excercise the option, do you have to purchase the shares of stock in the open market? If so, it seems like you would have to have quite a bit of money in your trading account.
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