Author: Orange

Options Trading

Options Trading

An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options are a type of derivative product.

The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option'

Leverage can be very powerful when it comes to investing because by using leverage it's possible to turn relatively small amounts of capital into significant profits. With many financial instruments, such as stocks, the only way to take advantage of leverage is to borrow funds to take a position and this isn't always possible for everyone. With some instruments, though, leverage is possible in other ways.

One of the biggest benefits of trading options is that options contracts themselves are a leverage tool, and they allow you to greatly multiply the power of your starting capital. On this page we look at exactly how leverage works in options trading and how it's calculated

Options leverage

Buying options contracts allows you to control a greater amount of the underlying security, such as stocks, than you could by actually trading the stocks themselves. Put simply, if you had a certain amount of capital to invest then you can create the potential for far higher profits through buying options than you could through buying stocks.

This is essentially because the cost of options contracts is typically much lower than the cost of their underlying security, and yet you can benefit from price movements in the underlying security in the same way.

Let’s assume that you had $1,000 to invest, and you wished to invest in Company X stock because you believed it was going to increase in price. If Company X stock was trading at $20, then you could purchase 50 shares in Company X with your $1,000. If the stock went up in value, then you would be able to sell those shares for a profit. For example, if they went up by $5 to $25 then you could sell them at $5 profit per share for a total profit of $250 (not accounting for any commissions on your trades).

Now let’s assume you decided to invest in call options on Company X Stock, trading at $2, with a strike price of $20. If the contract size was 100 you could buy five contracts at $200 each: meaning you effectively have control over 500 shares in Company X (5 contracts, each covering 100 shares). This would mean that using your $1,000 to buy options has given you control of 10 times as many shares as using your $1,000 to directly buy shares at $20 a time. With the price of Company X going up to $25, you would make a lot more money through selling your options at a profit than the $250 you would make in the example above.

That is essentially the principle of how leverage in options trading works, in very simple terms. This should illustrate why it's possible to make significant profits without necessarily needing a lot of starting capital; which in turn is why so many investors choose to trade options. To truly understand leverage in greater detail, you need to understand how it's calculated, which we have explained below

Options Hedging

One of the simplest ways to explain this technique is to compare it to insurance; in fact insurance is technically a form of hedging. If you take insurance out on something that you own: such as a car, house, or household contents, then you are basically protecting yourself against the risk of loss or damage to your possessions. You incur the cost of the insurance premium so that you will receive some form of compensation if your possessions are lost, stolen, or damaged, thus limiting your exposure to risk.

Hedging in investment terms is essentially very similar, although it's somewhat more complicated that simply paying an insurance premium. The concept is in order to offset any potential losses you might experience on one investment, you would make another investment specifically to protect you.

For it to work, the two related investments must have negative correlations; that's to say that when one investment falls in value the other should increase in value. For example, gold is widely considered a good investment to hedge against stocks and currencies. When the stock market as a whole isn't performing well, or currencies are falling in value, investors often turn to gold, because it's usually expected to increase in price under such cir[removed]stances.

Because of this, gold is commonly used as a way for investors to hedge against stock portfolios or currency holdings. There are many other examples of how investors use hedging, but this should highlight the main principle: offsetting risk.

Bull Call Spread

The bull call spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term.

Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying security and the same expiration month

 

 



Categories: Education

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Posted on: 05-09-2018 04:47:39 | Views: 35


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