Stock Option Trading

Trading stock options is almost like trading regular stocks. The difference is that instead of buying and owning a share in a company, you're actually buying the rights to buy shares of stock in a company at a certain determined price. The way you think about options will be a bit different than regular stocks and may need some getting used to.

For example, let's say you what to buy some a popular kid's toy as a Christmas gift and the cost is $20. Now let's say you think the price of the toy will go up as Christmas day gets closer due to more demand. If this was like buying regular shares of stocks, you would buy a bunch of these toys at $20, wait for the price to go up, and sell them for a profit.

With stock option trading, the scenario would be something like this: You think the price of the toy will go up, however, the seller things the toy is horrible and demand will go down bringing the price down with it. So let's say you somehow convince the seller to let you buy the toys at $20 whether the price goes up or down. The seller, convinced that the price will go down, agrees to your proposal. The problem is, you don't have the money right now to pay for a bunch of those toys at $20 a piece and you won't be able to get the money for a few weeks. By that time, the price could go up and you would've missed the opportunity OR the price can go down and the seller won't make anything off of you.

So in this case, what you do is you buy a contract for a few bucks that basically says, whether the price goes up or down or stays the same by a certain date, let's say on Christmas Eve, you have the right to buy a certain number of the toys for $20 each. If the price goes up to $25 for example, that contract you paid for gives you the right to buy the predetermined quantity of toys for $20. You can then turn around and sell all of it for a profit.

Of course, the price can go down just like the seller predicted. In this case, if the price goes down to $15 for example, you're not going to want to buy the toys for $20. You have the right but not the obligation to buy. In this case, the seller will make money from the contract you bought to buy the toys at $20.

In essense, that is what stock option trading is all about. It's buying and selling contracts that give you the right but, not the obligation, to buy stocks at a predetermined price. Now, what buying stock options also involve that regular stocks don't is a time limit. In the previous example, the time frame was by Christmas Eve. With all stock options, there will be a predetermined period of timie that you must exercise your option by or else it will expire and become worthless.

By "exercise", that just means using the contract you bought to actually buy the stocks at the predetermined price. By "expire", that means that once the time comes, if you don't use your contract to buy the stocks at a certain price, you won't be able to use it any longer.

So why would anyone want to trade options when there is a time limit? With stocks, you can basically hold onto it forever. With options, if you don't do something with the contract, either use it or sell it to someone else by a certain time, you lose your money. The reason is because with stock options, you can leverage your money.

Let's look at an example. If a stock for Walmart costs $50 a share and you only had $1,000, how many shares of Walmart can you buy? 20 shares (1000 / 50). So if you own 20 shares of Walmart at $50 and the price goes up to $55, you will make $100 (20 shares x $5) which is a 10% gain. As you can see, if you want to make a lot of money with stocks, you need a lot of money in order to buy enough shares to make any real amount of money. If you had $1 million, in the same example with the $5 increase in Walmart's stock price, you would've made $100,000.

Advantages

With stock options trading, you can actually invest less money and yet make more than by buying stocks the normal ways. The reason for this is that the contracts you are buying are a lot cheaper than the stocks. $50 increasing to $55 is just a 10% gain. $1 increasing to $5 is a 500% gain. Because stock options are less expensive, you can make more money buying quality companies.

So why don't you just buy $1 stocks? Besides low cost stocks being risky, the chances of a $1 stock going up a $1 isn't very high. For a $50 stock to go up $1 is quite normal. The cool thing about stock options is that a $1 increase in a $50 stock can make your stock option go up by around 50 cents. This doesn't sound like much but considering stock options costing a few bucks, a 50 cent gain is a pretty big return on investment.

Walmart Example Using Bigcharts.com

At the time of this writing, Walmart stock is at $49.36. It's July $50 call option price is $1.66. With options, you always have to buy 100 shares at a time, which is called a contract. So each stock option contract consists of 100 shares of stock. So in this case, for 1 contract, you would pay $166 ($1.66 x 100). The "July" part is the month the option will expire. Right now, we're in May so by the 3rd Friday of July, we need to either sell this contract to someone else or we need to exercise the option and buy 100 shares of Walmart stock at $50 each or choose to do nothing and lose the $108.

The $50 is the strike price. With basically means we think Walmart's stock will be worth at least $50 or more by the 3rd Friday of July (it's always the 3rd Friday of whatever month you choose). In this scenario, if the stock price goes up to $55 for example, our option price is very likely to go up to about $3 depending on how soon it can reach $55 among other factors. So for this example, you would've made a 80% gain on your money ($1.66 going to $3) which in dollar terms means you would make $134 off of your $166 investment. Compare that to making only $100 from buying $1000 of Walmart stock. That's the power fo trading stock options.

Disadvantages

The biggest disadvantag to stock option trading is that it can be very risky. Yes, you can make a lot of money and the returns can be tremendous, but the opposite is true as well. You can lose a lot of money really fast if you don't know what you are doing and don't abide to strict money management rules.

Hopefully, you kind of get the idea of how powerful stock option trading can be. This can be quite confusing if this is your first time being exposed to stock options, I haven't even covered calls and puts yet. You can find a lot of this information. You can find out more about the basics of this type of investment by doing to this Motley Fool website.

In a future hub, I'll actually be diving into some sound strategies you can use to start making some money with stock option trading. Keep in mind that with any investments, there will be risks. As mentioned earlier, the risks involved in options trading, if you don't know what you're doing, can be extremely high. Only invest money that you can spare to lose and only start investing once you have a lot of experience paper trading (fake trading).