I would like to take a moment to explain option trading to those interested in it but not necessarily knowledgeable about it.
I have to be honest, it is not exactly easy to explain option trading because of the wide variety of products on the market today.
What I would like to do by the end of this article is be able to show you how with even as little as $100 you can get your first exposure to options markets and explore them yourself while spending less than the cost of a textbook.
It is honestly much easier to show someone how options work rather than trying to explain option trading.
Options markets were formed by some astute Wall Street traders who had clients with a much greater appetite for risk than their old money counterparts.
These new markets were designed to help people increase their returns in the market by boosting their buying power.
A normal person goes into the stock market and buys 100 shares of GE at $13.
50.
The option trader goes into the market and buys 1 contract for the right to buy 100 shares of GE.
What's the difference? At today's market prices the fellow buying the contracts pays $1.
68 for the right to buy shares (called a call contract expiring in June) of GE at $12/share.
How does that add up numbers wise? It costs the basic investor $1350 to buy his 100 shares of GE.
It costs the options trader $168 to buy his contract (sold in units of 100 - $1.
68/contract * 100 units = $168).
In addition, if the contract buyer wants to buy the shares (excising his right to buy the 100 shares), he will have to pay $1200 for them ($12/share times 100 shares).
Remember, the contract buyer has purchased the right to buy shares of GE for $12 each.
In total the cost of the contract is $1368, which is $18 more than the price of the basic shares.
Does it make sense to do this? The answer is sometimes.
The key is the expiration.
The right to buy shares expires the third Friday of the month of June, in this case June 19th at the close of business.
If GE's stock price rises significantly before June 19th, then the contracts can be worth much more than the stock itself.
Consider this: If GE stock price goes to $14/share on or before June 19th, the 100 shares are worth $1400.
A person holding $12 GE Calls expiring in June would be able to exercise them, paying $1200 for the shares and be immediately able to sell them for $1400, netting $32 ($1400-$1368=$32).
Doesn't sound like much does it? Recall I have tried to explain option trading with a simple example.
The return on investment for the contract is $32/$168 = 19%.
The return on the stock itself is $50/$1350 = 3.
7%.
The option paid off 6 times as much as the stock itself.
Still..
..
$32 doesn't sound like much does it.
Let me explain option trading a little further.
If the contract trader had invested as much money as the stock holder, he would have been able to buy 8 contracts of 100 shares each, spending $1344.
When GE then moves to $14/share, the options can be exercised, netting $32 per 100 unit contract as before, only now for apples to apples comparison we have 8 contracts, so our cash return is $256 (8 times $32 profit per 100 unit lot).
This amounts to $206 more than the stock holder ($256-$50).
This should explain option trading a little better.
You should now be able to see how using this investment strategy allows a person to put less money at risk ($168 vs.
$1350) and earn a higher return (19% vs.
3.
7%).
This can be a highly efficient way to invest for higher returns.
When I set out to explain option trading what I have neglected to mention is the relatively high barrier to gain access to this market.
Most brokerages require a minimum of $10,000 to open an account.