This entry was posted on Wednesday, November 4th, 2009 at 9:40 pm and is filed under trade options, trading options. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
Folk wanting to know how to trade options will quickly come to understand why trading options is a much more sensible and less risky business than trading stock, provided of course that they have taken the necessary steps to minimize risk.
So, why are options a better trading vehicle than stock? Let me illustrate with the following example. Let’s imagine that stock in company XYZ is selling today at $50. If I was to purchase 1000 shares of stock XYZ, in the expectation that this stock is going to go up, (in other words I am bullish on the stock), the stock will cost me $50,000. Although the stock may indeed go up, if things go belly up I stand to lose the whole $50,000 I have invested.
The alternative is to seek out a call option on the XYZ stock. Let’s assume that a three month call option contract on stock XYZ, which today has a strike price of $50, is selling at a premium of $12. If I take this up, I have the right but not the obligation under the contract to buy 1000 shares of stock XYZ for $12 a share. If I choose to exercise this option (no pun intended), my cost for the stock is $12,000. Immediately I have saved myself $38,000 by choosing to trade options and not stock and this saving can be used to purchase further option contracts.
Now in the same way that stocks can go up they can also go down. If I had purchased the stock for $50,000 and the price plummets to $25 a share, I have lost $25,000. If I had invested in options? $12,000. But that of course does not reflect the reality of the situation. As you will already have discovered from my earlier posts knowing how to trade options is all about covering your calls (akin to hedging your bets at the racetrack) so as to minimize risk and ensure you will want to continue learning how to trade with confidence! And the secret is not just to simply walk away once you have done this but to return to adjust your position(s) as and when the need arises. More on that in my next post!