Understanding option trading is one thing that many stock traders fail to accomplish. Trading options can increase your yearly return, provided you use the proper methods to accomplish this. The main advantage of options is leverage. For instance, while you may only have enough cash in your account to buy 100 shares of a specific stock, if it is optionable, you may be able to control 1000 shares of the same stock, at least for a while.
While many traders feel that dealing with options is a risky business, like anything, a bit of education can go a long way to reduce the risk. In theory, if you purchase a good company and things go wrong you can hold it for years hoping that someday it will go up. However, with options this is not the case. All options have an expiry date which is generally any time from the day you bought it up to 9 months after you purchased it. After the expiry date, if the option is out of the money, then it is worthless and you own nothing.
To explain options you need to know that there are two types of options which you can buy – calls and puts. A call option gives you the right to buy a stock at a set price sometime in the future. A put option gives you the right to sell a stock at a set price sometime in the future. From these many different types of strategies can be identified such as covered calls, straddles, spreads, strangles and butterfly strategies. This website will only review buying and selling calls, puts and writing covered calls. If you would like to get a feel for how to write covered calls, please view an actual example of a covered call strategy.
Let us look at an example of an option without considering commission charges. On November 18, 2006 Home Depot (HD) appeared to break out of a consolidation pattern on good volume. You could have picked up 100 shares of stock at a closing price of $38.28 for a total of $3,828. However, you also could have purchased the May $37.50 call at the same time for approximately $3.00 or $300 as each option unit controls 100 shares of stock.
Now what happens. Options expire after the close of trading on the 3rd Friday of the month. Therefore, on Friday May 18, 2007 if HD closes above ($37.50 + 3) or 40.50 you will make a profit. If HD closes below $40.50, you will lose on the trade.
Now let us look at the leverage. If HD closes at $43.00 on the 3rd Friday in May 2007 then you would have made $472 per 100 shares or $250 per option. While you made more money by buying the stock your return was only 12.3% vs an 83.3% return on the option. This is one of the main reasons people enjoy trading options.
But remember, it is stated in many places that the number of options that expire worthless is above 70%. Therefore, you need to understand how to trade options before you become one of the owners of one of the 70% of options which expire worthless.
Our option trading strategies page contains an example of how you can carry out simple option trading strategies which may help you.