Have you ever been told that trading options are too complicated to understand or too risky to invest in? The truth is options are no more complicated than buying a stock. Learning how to trade options can actually help you reduce your investment risk! This article will show you the power of options trading, give you a basic understanding of how trading options work and the real risks of investing in them.
We will start by looking at a call option, a term you may have heard of before. A call option gives you the right to buy 100 shares of a specific stock, at a specific price, at some time in the future. You’re not buying the actual stock at that moment, but instead the option to buy that stock at a later date for a fixed price. The great thing about the call option is that you are not actually obligated to buy the 100 shares if you don’t want to and you can sell this call option to someone else at any time.
This may seem a little complicated, but this short video should help you understand the basics of options trading.
Options Trading Example: Ford
Here’s an example that will help you understand call options and their benefits more clearly.
You believe that Ford Motor Company has really gotten its act together in the last few years and you want to invest in their future. If you know nothing about options and how they work, you would place an order to buy 100 shares of Ford (F) @ $13.98. This trade would cost you $1398 (plus commissions). You now own 100 shares of the stock and your upside profit potential is limitless, while your maximum loss is the $1398 that you invested in buying the 100 shares of Ford stock.
With a call option on Ford, you can still participate in the upside potential that owning 100 shares of Ford stock offers but reduce the amount of money that you have at risk. Let’s see how this is possible by trading options on Ford instead of buying the 100 shares of Ford stock.
If you think that in the next few months the stock is going to rise significantly, you might want to buy (1) Ford December 16, 2016 $14 call option @ $.69. This will give you the right to buy 100 shares of Ford stock at a price of $14 at any time until December 16, 2016 when this right to buy those shares expires.
That date is known as the expiration date and the price that we chose, in this case the 14, is known as the strike price. The cost of this call option or right to buy Ford @ $14 until that expiration date is 100 shares X $.69 or $69.00. If the stock goes to $20 by December you would be able to sell the option for at least $6.00 or $600 and make a nice $531 profit.
You can also choose to exercise the option and go ahead and buy the stock for $14 even though it is currently trading @ $20. You would still have an unrealized profit of $531. If you look at this example you end up with a profit that is only $69 less than if you bought the stock outright, but you only had $69 of cash at risk. This is important especially if you are wrong about Ford and the stock price drops to $8 during that period. With the stock purchase you would be losing $598, but with the option purchase you would have only lost $69.
This example shows how options trading strategies can prove to less risky than owning stock outright. Call options are great investments to own if you think the price of a stock will rise in price and you don’t have a lot of money to invest.