Options trading provides a unique investment vehicle to even the beginner investing in the stock market and provides many advantages including leverage, limited risk, insurance and profits in bear markets.
Leverage
Leverage is the ability to “buy in bulk”. First, remember that in options trading you are not actually buying or selling anything. This is an agreement between two investors if a transfer of assets actually takes place. Also take note that when someone buys an option they pay an amount known as a “premium” to the seller; this premium is the cost of the option.
That being said, leverage in options trading occurs when purchasing options. In the U.S., options are traded with a contract multiplier of 100; this is the number of shares per option traded. With this contract multiplier, even small investors are able to trade a large exposure, or leverage, on a small amount of capital. Successful trading in this manner can be quite profitable.
Limited Risk
Limited risk is another tremendous asset of options trading. Whether you are learning how to invest in the stock market or you currently have limited funds to invest, options trading offers a perfect vehicle for your trading. When you are trading options, you have a great advantage over traditional stock trading because you can take a view on the 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’s have a little option trading education. We have decided to buy an option on MEW Industries with the following information:
- Company: MEW Industries
- Option Type: Call Option
- Position: Long
- Strike Price: $20
- September 8th
At the time of the trade, MEW Industries was trading at $25; the Call Option was trading at $6.50. This is known as the premium and it is the amount we paid for the right to possess this option. Therefore if we take into account the premium and the strike price, we will break even at $26.50; anything less would be a loss and anything more would be a profit. The beauty of options trading in the stock market is that if the stock price falls, we can simply allow the option to expire and lose only the premium. While this can be expensive, it is far better than being forced to buy one hundred shares $15 stock for $26.50 each!
Unlimited Profit Potential
Now you should be able to see how this type of options trading 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. While this sounds very bad, once you understand the options available to you and how to use them, you can limit even the unlimited risk of a sell strangle! (if you don’t know this options trading strategy, click the link)
Insurance
There is another way in options trading to protect yourself and your stock portfolio; this technique can give the investor who is uncomfortable with exposing himself or herself to risk some insurance. Options such as a Put Hedge can insulate an investment even during bearish periods.
A put hedge is the stock option trading strategy of buying puts during a bearish market to protect stock shares that, while the trader is reluctant to sell, are vulnerable to a decline in the market. Successful traders utilize strategies such as a put hedge to insulate their portfolios from loss in a bearish market. This method also has the potential of unlimited profits, while at the same time limiting the potential loss by the investor.
Conclusion
Options trading is a valuable and unique way of learning to trade in the stock market as well as making consistent profits without tremendous outlays of capital. While there is risk with options trading, it is usually limited and it has the ability to make you quite the successful trader.
