Learning the Ropes of Options Trading

Learning the Ropes of Options Trading

Options are often misunderstood by investors, but if grasped, they can be used in a wide variety of portfolios. Trading options is a great way to hedge your portfolio and gain cheap control of a company's stock, both of which can lead to substantial rewards. More so, the risk associated with options is extremely low. You can lose no more than your initial investment plus any fees incurred in an option trade.

So, what can one do? Options are investments that offer you the right, for a set period of time and at a predetermined price, to purchase or sell the underlying security.

Options allow you to speculate on the future direction of a stock, but only for a set time frame (often between one month and three years, depending on the option chosen). So that you can see how options might lead to amplified profits with low risk, let's go through a handful of instances with varying conditions.

Let's pretend you think the refinery sector's gas needs will boost Valero's share price. You're wagering that the market will be taken aback by the company's ability to beat expectations when quarterly profits are reported in June.

You would look to purchase "call options" on Valero in this situation. A call option is a wager on an increase in the stock price. Conversely, purchasers of put options wager that the value of the underlying security will decrease.

You should give yourself enough time to double-check your assumptions about the trade without making it too expensive to actually complete it. Because their worth diminishes over time, options are often called "wasting assets."

The premium increases in proportion to the time remaining until the option's expiration. The "premium" of an option refers to the cost of purchasing it. The premium on a costly option is higher than that of a cheap one. Like the prices of stocks, option premiums are set by the market. Like stocks, options can be bought and sold on a centralized market.

As an additional piece of information, options lapse every three months on the third Friday of the month. To capitalize on Valero's earnings announcement in the final week of June, you should invest in an option with an expiration in July. That's why it makes sense to speculate on a price increase in Valero stock by purchasing a call option in July. To be "in the money" means that a position is profitable, or "at the money" in American English. When a deal does not result in a profit, it is said to be "out of the money," while a trade that results in no loss is said to be "at the money."

So that the option is "in the money" when sold, how much would you have to pay for it? Let's pretend Valero shares are $60 apiece right now. You anticipate a gain of roughly 10% after the market learns of your profits. Assuming a stock's price of $66 represents your bullish prediction, You check the available strike prices for Valero July Call options and discover that there are two of them: $60 and $65. You decide to invest in the Valero 60 July Call.

The $60 price point represents the strike price of the option, or the minimum price at which the underlying stock may be purchased or sold.

Since you may expect few others to share your optimism, this option will cost you only about a dollar. Option purchases are restricted to multiples of 100. Thus, each option contract would cost you $100. The premium for five contracts at this level is $500. As a result of investing $500, you have the power to buy 500 shares of stock. Consider this. At a price of $60 per share, buying 500 shares of Valero stock would cost you $30,000. Purchasing the same number of shares through options would cost you only $15,000.

The risk of losing more than your initial investment is never greater than what you put into an option, which is another perk. If the trade goes against you, the most you stand to lose is the cost of the option and any applicable fees. If the trade goes in your favor, however, the leverage in options can significantly increase your earnings from even a modest change in the underlying stock price.

Options can be used for many different strategies, but the main benefit is that they reduce the cost of controlling large blocks of stock to almost nothing while limiting your loss to the option's purchase price. When options are used in this way, using good directional methods and systems can lead to enormous profits.

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