4 Reasons To Trade Options.

Options Trading 101 - The Ultimate Beginners Guide To Options

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by Gavin in Blog
February 18, 2011 0 comments

Control more assets for less money / trade with leverage

One of the great advantages of trading options is the leverage they provide. Options allow you to gain a large exposure to a stock or index for a fraction of the cost of buying shares outright. You can also choose the degree of leverage you require by choosing in-the-money or out-of-the-money options. Out-of-the-money options are cheaper and therefore will have more inherent leverage than in-the-money options. The further out of the money you go, the greater the leverage.

Using an example, say we want to use options to gain exposure to a stock trading at $40. A $30 call option in trading at $10.20, and $40 call option is trading at $2 and a $45 call options is trading at $0.50. Let’s assume that at expiry, the stock has risen to $50.

The $30 call is worth $20 for a total gain of $9.80 or 96.08%

The $40 call is worth $10 for a total gain of $8 or 300%

The $45 call is worth $5 for a total gain of $4.50 or 800%

You can see that the greatest return in percentage terms was achieved by the out-of-the-money option due to the higher amount of leverage. However, it should be noted here that the out-of-the-money option was the most likely to expire worthless or achieve a 100% loss as the underlying stock needed to rise 13.75% before it made any money. The in-the-money option, had the lowest return in percentage terms, but the highest return in dollar terms.

Leverage is a very powerful tool, if it is used correctly. You need to make sure you understand all the risk and rewards of using leverage before employing this as an investment strategy.

Trade for income.

Another great feature of options is their ability to generate income. You can generate income on an existing portfolio through the use of covered calls, or you can use neutral strategies such as credit spreads or iron condors to generate monthly income in a sideways trending market.

Covered calls are a great way for beginner options trader to start out by selling out of the money calls on an existing stock portfolio. Generally investor who write covered calls in this fashion are looking to earn around 15% income per year.

As an example (I don’t recommend this strategy with the market at its current loft levels), you could buy the SPY for 133.69 and sell a March 135 call option for $1.35. Purely from the option premium, you are earning just over 1% in around a month, or 12% per annum.

Another method for generating monthly income is by using iron condors and credit spreads. These are more advanced strategies, but when used effectively can produce significant monthly income. Some investors trading iron condors and credit spreads look to make around 8-10% per month.

Profit from declining stocks.

I can’t remember when I found out about put options, but I can remember that I was amazed at the time. I had been investing since I was 13, but I had never done any sort of trading. I always knew you could make money selling stocks short, but puts options were a new ball game entirely. It seemed so easy to just buy some puts options on stocks you thought were headed south. Unfortunately for me my first attempt at buying puts was unsuccessful, but it was only a small position.

Binary options are a becoming increasing popular and are very easy for beginners to understand due to their “all or nothing” payoff. There are a couple of worthwhile binary options affiliates programs available today.

Profit from volatility or protect against unknown events

Puts options are also a great way to protect your portfolio against volatility or unknown events. Using puts in this manner is similar to buying insurance for your home. You pay a small premium and are protected (to some extent) in the event of loss. Some people are just born worriers. Whether it’s a stock market crash, losing their job, or that they’ll run out of clean underwear, some people just seem to worry about everything. Sure, there is always the risk of a stock market crash, but there is no reason why people shouldn’t participate in one of the greatest wealth creation vehicles when there is insurance available. Buying puts will come at a cost, just like insurance, which will mean lower returns, but wouldn’t that be worth it for the born worrier to be able to sleep at night?

Options Trading 101 - The Ultimate Beginners Guide To Options

Download The 12,000 Word Guide

Get It Now