You’ve heard the term options trading, and you’re curious as to what they are, how they work and if you should trade them. You’ve come to the right place to discover what are options all about. We’ll answer those questions and more in this article.
What are options in stock trading?
Options trades are financial derivative instruments that are traded on the Chicago Board of Option Exchange (CBOE).
How do options work?
When trying to understand what options trades are, you must know two types of stock options: call options and put options.
A call is an option contract that gives you the right, but not the obligation, to buy 100 shares of the underlying asset (stock) at a specified price (strike price) during a fixed period of time (until expiration).
Calls increase in value when the price of the underlying asset rises.
A put is an option contract that gives you the right, but not the obligation, to sell 100 shares of the underlying asset (stock) at a specified price (strike price) during a fixed period of time (until expiration).
Puts increase in value when the price of the underlying asset falls.
Once the contract deadline passes, the instrument expires. If the option is in the money, the stock price has moved higher than the strike price. The contract is settled in cash or exchanged for shares.
If it is out of the money, it means the stock price has not yet moved higher than the strike price and the option expires worthless.
Still with me? Great. Because know we are going to talk about the fun part.
What are options trading advantages?
There are four advantages to trading options rather than trading stocks.
Options cost a
fraction of stocks
Let’s say Apple is trading at $275 per share. You might be able to buy one Apple call option for $6. That $6 gives you the ability to control $27,500 worth of Apple stock. Crazy, huh?
Essentially, trading options allows you to trade top tier names while risking significantly less capital than stock trading.
Options trades provide tremendous leverage
Options contacts follow movements (up, down and sideways) of the underlying stock – but with larger potential returns. Sometimes, you can enjoy 5, 10 or even 20 times the rate of return of the underlying asset.
Here’s how this looks in real life. It’s March, and Apple is trading at $258. You buy Apple calls at $5.50 for an April strike of $265. One week later, Apple releases a Q1 earnings report that was even stronger than expected, and the stock shoots up to $270. Your calls were now worth $11.30.
You just gained more than a 100% with that Apple call trade in less than two weeks. Meanwhile, the stock gained 4.6%. That’s a 20:1 leverage ratio!
Options trades are short-term trading instruments
As you can see in our Apple example above, options trades don’t require you to tie up cash for years or decades in order to grow your portfolio. Sure, you can roll one option trade up to an expiration date that is further out, but you’re still only tying up a small amount of cash for several weeks.
Options trades expire daily, weekly, monthly and quarterly. As long as you practice good risk management and only trade a small portion of your portfolio, you won’t have much cash tied up in options contracts on any given day.
Options can provide steady income
At Explosive Options, we trade options for income, and many members of my options trading services do, too. If you practice good risk management and use this leverage wisely, you can earn a steady income and grow your trading portfolio.