Monday, June 1st, 2020

The Leverage of Trading Options


The leverage of trading options is perhaps its greatest attraction. With the simple investment of a premium a trader can nail down a price at which he or she will be able to buy or sell an equity, no matter high or low the price may go. The leverage of buying  and selling options is that after paying the premium the trader may make a profit of the difference between the strike price, the agreed upon contract price, and the spot price, the price at which the contract will be settled, minus, of course, the cost of the premium paid to buy the options contract. When asking what is an option worth, the trader should think of the multiple of initial investment that can be gained with a successful options purchase.

Besides providing investment leverage, buying options provides the trader with an opportunity but not an obligation to purchase or sell equities on or before their options expiration dates. Because the options trader is not locked in to buying or selling the underlying equity he or she can only experience the loss of the premium if the stock or other equity does not change in price as anticipated.

The leverage without excessive risk in options trading lies in two kinds of options trading. These are buying calls and buying puts. In buying a call the options trader will pay a premium for the right to buy a stock or other equity on or before the contract expiration date. The price he or she will pay will be strike price, the price at which the contract is written. If the price of the stock goes up substantially he or she will profit handsomely. If the price does not change the trader has only lost the price of the premium. In buying a put the trader purchases the option to sell a stock at a given price, the strike price, no matter how low the price might go. In this case the trader will hope for the stock price to drop substantially and if it does he or she will buy at the new and lower spot price while simultaneously selling at the higher strike price.

Using technical analysis of market trends the trader will attempt to predict where a stock price will go and make the appropriate trade. In both buying calls and buying puts there is the potential for substantial profit. This is the leverage of trading options. The new trader may ask when is trading call options a good option and when is trading put options a good option. In both cases of buying options, puts or calls, it is a good idea when the trader expects to see substantial price movement in a given direction. In the case of buying calls the trader will be expecting upward movement and in the case of buying puts he or she will be expecting downward movement. In the case that the expected price movement does not occur the trader is only out the premium

The leverage of trading options lies in buying calls and buying puts. However, there is statistically more profit, with wise trading, in selling calls and selling puts. When the trader correctly picks stocks that do not move in price he or she gains the premium for each option. The problem with uncovered options trading in selling calls or puts is that a substantial price change can be very expensive to the point where the leverage of trading options works in reverse. The trader gains a premium but needs to pay substantially to settle the contract. Traditionally it is large institutional investors and people who are making a living trading options who have the skill and the deep pockets to successfully sell puts and calls.

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