Picture Framer Forex Trading & Twibbon Templates for Any Campaigns
Every day, shares worth trillions of dollars are purchased and sold on the world’s largest stock exchanges. In search of profit, traders and investors can participate in the purest form of capitalism on any given day by putting their money at risk by investing in any of the world’s top multinational firms. However, there is another method of speculation, options trading, which might be vastly preferable to trading the shares of a particular firm.
An option is a derivative of an underlying security that confers the right, but not the duty, to purchase the underlying security at a predetermined price. Each option controls up to 100 shares of a specific company’s stock and comes with varying strike prices and expiration dates, allowing for a huge degree of power. These benefits make options a superior trading instrument compared to equities.
One advantage is leverage. Leverage is the capacity to control a massive asset with a small quantity of capital. As in real estate, where a modest down payment allows a prospective buyer to control a large piece of property, options allow the trader to control up to 100 shares of stock for a small amount of capital, or “premium,” which is the actual cost of the option.
Consider an illustration of why options are superior to stocks when utilizing leverage. If you observe that ABC stock is poised for a rise and is trading at $50 per share, you may purchase 100 shares for $5,000. After a few weeks, ABC stock has risen to $60 per share; if you sell all of your shares, you will have earned $1000, or a 20% return. Not too awful.
Your friend, however, observes the identical situation with ABC stock and chooses to purchase an option with a $50 strike price and a $2 premium for a total cost of $200 ($2 x 100 shares = $200). ABC stock surges to $60, and your friend sells his $50 strike option for $1,200, representing a return of 500%. That is the power of leverage in options trading.
Traders can create income by employing credit spreads with options, which is another advantage. If you observe that ABC stock is in a trading range and remains above support at approximately $50 per share, you can establish a credit spread by executing a Bull Put Spread. You sell the current month’s $50 put option and pocket the premium, then acquire the current month’s $45 put option as protection against a sudden drop in the stock price. Then, sit back and collect the difference between the premium obtained for selling the $50 put option and the cost of purchasing the $45 put option upon the options’ expiration date.
ABC stock can increase or remain around $50 and the position will still be profitable. It may even go below $50, the cost of the premium paid, and the position would be profitable! The only way the trade might incur a loss is if the price fell below the breakeven mark. Numerous option traders specialize only in these sorts of option spreads and frequently produce returns of 10% to 90% each position!
A third advantage is that options allow you to short stocks without the constraints associated with short-selling stocks. When shorting a company in expectation of a price decline, in addition to incurring a bigger cash outlay than when purchasing put options, you must also pay interest on the borrowed shares and any dividends that the stock may pay during the period you hold it. With put options, you may avoid all of these disadvantages and earn returns considerably more quickly, as stocks typically decline twice as quickly as they rise.
In addition, if a stock is rumored to miss its earnings predictions, you can make a great deal of money quickly by trading negative earnings releases in the appropriate market situation. The reason for this is that stocks can frequently gap down by 50 percent or more in response to negative news. A savvy option trader can generate a substantial profit without tying up a lot of funds.
This also brings up the most significant benefit, which is that you only risk the premium you paid for the option itself. If a stock gaps up or down in response to news and you are on the opposite side of the trade, you only risk a small portion of your cash, however if you had purchased the stock you could lose half your position overnight! Early in 2006, Google reported solid earnings, but not as strong as Wall Street had anticipated, resulting in a severe price decline. A few weeks later, Google’s Chief Financial Officer said publicly that the company’s future growth would be temporarily slowed, and the price fell. If an options trader had been long Google call options at that time, he would have only lost a small portion of his overall trading capital compared to someone who had purchased the stock itself (Google’s stock had been as high as $475 prior to these events and then dropped nearly 150 points in a matter of weeks).
The few benefits listed here pale in comparison to the dozens of benefits that options offer traders who are disciplined enough to understand them. Stocks have been compared to the game of checkers, but options have been compared to the game of chess due to the immense possibility and flexibility they offer traders and investors. Stock and option traders who take the effort to understand and implement a few simple option methods can better analyze market risks and perhaps position themselves to benefit handsomely.