If you have heard people discuss options trading and have never looked into the topic but want to know what it is then this guide is for you. The Basics of the subject aren’t difficult to pick up although it can get pretty advanced, especially if you start looking into the different strategies that can be used. We will keep it simple for now.
What is an Option?
An option is a feature packed derivative that allows traders to speculate on the price movement of underlying assets. When a contract is opened, the buyer pays a premium that restricts the losses they can incur. Hopefully the price of the stock they are trading will increase bringing a profit. If it doesn’t though and the price goes down, the trader is limited to losing the original premium they have paid.
“Why is this?” I hear you ask! Well this is because the buyer of the contract has the ‘option’ to complete the purchase of the stock or simply let the contract expire, incurring the loss of the premium paid.
An example of an options trade:
The company Teddy Bears Inc. is currently trading at $10 a share and the broker charges a $50c premium on every share to open the trade. This means that to buy the equivalent of 100 shares, it is going to cost the trader $1050. As you can see, they have basically been charged $50 to insure their losses. Say the price plummets to a two year low of $4 – the trader will still only lose the $50 premium they already paid. If the company goes into liquidation, the contract holder will still only lose the $50. If on the flip side, the share price shoots up to $20 a share, the holder will have made $950 clear profit (9.50 per share profit x 100 shares). Now you can probably see why the trading of options is so popular!
The above example is very simplistic. It doesn’t take into account the leverage that the broker will provide although the end result will be exactly the same.
What is Leverage?
Leverage is one of the most enticing features of options trading. Many people talk about leverage as a get rich quick scheme and although it can be used to make large gains, equally large losses can be incurred too. Leverage provides traders with well, leverage, when opening contracts. This means that they can take out positions worth far more than the money in their account. As long as they have enough funds to cover the premium, the trader can take out considerable positions with inconsiderable amounts of money.
How Much Leverage do Brokers Offer?
This is not an easy question to answer as all brokers are different, depending on their risk appetite and how risky they deem the market you wish to trade in to be. Some companies are considered to be more stable than others and less margin will be required to open a trade with these less risky shares.
How Much Money can be made?
Profits in options trading are limitless. Depending on your risk/reward appetite, you could make some serious sums of money overnight. Of course it is not as easy as this and you really should be careful and only risk money you are willing/can afford to lose.
How Much Money do I Need to Get Started
This depends up on the stock you are looking to trade. In the US, shares are often sold for XXX each and with an options contract; you purchase them in 100 share blocks. The value of 100 shares can often be considerable in which case you are going to need a good sized pot of money to draw from. As a guideline, anyone who is looking to start trading options should think about doing so with a minimum of $2000.
What Costs Will I Incur?
Brokers vary with their pricing but as a general rule, expect to be charged a fee for opening a contract and also a premium on the underlying stock price. The premium will calculated using a number of metrics: Time Value, Volatility, Interest rate and Dividend. To cut a long story short, the higher risk a share is considered to be, the higher premium you should expect to pay when buying the option.
Are There any Other Alternatives to Options?
If you are looking to have the feature of not having to commit to the actual purchase of stock but would like the opportunity to, then vanilla options really are great options to choose. If this aspect isn’t so important then you might want to take a look at other derivatives such as Contracts For Difference and spread betting. With these two alternatives, you are essentially speculating on a financial asset price movement but you do not have the security (or the cost) of an option.