Do you often hear about options from experienced investors?
You may hear that options have higher leverage, and can make 5 to 10 times return on investment in a single trade. But you can lose everything if you are wrong about the market direction?
Today we start with the basics of options trading, and use profit analysis charts to show the differences in leverage. So you can quickly understand what are options.
What Are Options?
An option is a right to trade stocks at a given strike price before a given date.
These are the key components of an option contract:
- Put option - the right to sell stocks
- Call option - the right to buy stocks
- Strike price - the agreed price to trade stocks
- Expiration - the deadline to exercise the right of the option
- An option contract in the US stock market is 100 stocks
If you own an option, you can sell (Put) or buy (Call) 100 shares at the strike price before expiration.
Profit Analysis of Trading Stocks
Let's start by revisiting the profit analysis of stock trading, o you get a better understanding of the leverage of trading options.
If you believe AAPL price will fall soon, you can short the AAPL to make money when the stock price falls. But you'll lose money if the price rises instead.
No matter you long or short stocks, the probability of profit is 50%. As long as you hold the position and Apple stays in business, the stocks you own stay valuable.
What Is a Put Option?
A Put option is a right to sell 100 shares at the strike price before expiration.
Looking at the AAPL price now, if we long a Put option at $120 that expires next month, it costs us $1.58 per share for this Put option contract. Since each contract is 100 shares, we spend $158 in total.
The profit analysis of a long Put is similar to shorting stocks. If the stock price falls below $120 before expiration, you can buy cheap AAPL stocks from the market, then exercise the Put option to sell the stocks to the Put seller for $120 and pocket the difference.
But if the stock remains above $120, the option expires worthless and you lose $158.
If we combine the profit analysis of long Put and long stocks, you can see the Put option is insurance against a market crash. The long Put limits your maximum loss by giving you an opportunity to sell 100 stocks at the strike price, no matter how far the market falls.
What Is a Call Option?
A Call option is a right to buy 100 shares at the strike price before expiration.
Looking at the AAPL price now, if we long a Call option at $130 that expires next month, it costs us $1.55 per share for this Call option contract. Since each contract is 100 shares, we spend $155 in total for this trade.
The profit analysis of a long Call is similar to a long stock position. If the stock price rises past $130 before expiration, you can exercise the Call option to buy 100 AAPL stocks at $130, then sell them at the market price for profit.
But if the stock price remains below $130, the option expires worthless and you lose $155.
If we combine the profit analysis of long Call and short stock, the Call option is insurance against the market boom. You can use long Call to limit the exposure to your short stock position when the price goes up by buying 100 shares at the strike price.
Differences in Leverage Between Options and Stocks
Since long Call is similar to long stock position, we can use profit analysis to look at the differences in leverage.
If you have $155 to invest, you can either long 1 stock of AAPL using $125, or spend $155 to long a Call option at $130 that expires next month.
If AAPL rises to $140:
- A long stock position makes $15 in profit or 12% return
- A long Call position makes $845 or 545% return
If the stock price remains below $130 one month later, the value of the long Call option becomes $0 (lose 100%).
If the market goes according to plan, the leverage on options can make 5 to 10 times per trade.
But if we are wrong about the market, while the stock position drops in value, the option expires worthless.
If you have any question about trading options, please visit other articles or leave a message below.