Options trading is an extremely popular way of speculating on the price movements of underlying financial assets - most commonly stock prices. I have written this guide to give you a brief overview of how options trading works and to highlight the main benefits of it over other forms of investment.
What is Options Trading?
Options give the trader, the option to purchase or sell (we will come to this later) a pre-agreed number of shares in a company at a pre-determined price. Contracts are built on a 100 x share basis so when you open one contract, you are essentially betting on the price movement of 100 underlying shares in Company ABC. At any point until the expiry date of the contract, you can close out your position at which point you will bank any profit (if one has been made).
Options are so called because the trader is never committed into fulfilling the purchase of the stock - they pay the brokerage a premium that is built into the price. Therefore if the price of the stock goes against you, you can simply let the contract expire. If you have opened a 'call' trade expecting the price to rise and the company goes bust, you cannot lose any more than the premium you have paid to open the trade. This is the beauty of options trading - unlimited profits but limited risk
Other Benefits
One of the other popular attractions of options trading is the leverage that companies offer their clients. Leverage (or margin) allows people to take out positions in a company worth considerably more than the funds required on day one. In many cases you will only be required to put down 10% of the total value of the stock value. In this instance, if you were to open a contract in Company XYZ where the share price was $5, one contract would be worth $500; you would only need $50 up front to open the trade. This is a simplistic example though that does not include the premium that the brokerage will have built into the price.
Although options trading leverage is considered to be a major advantage over other forms of investment, due to the massive profits that can be made, it is also a high risk feature. Huge losses as well as gains can be incurred so caution should be adhered to at all times.
Another attractive feature is that you can speculate on prices going up, or going down. When you physically purchase a company share, you can only really put your money on it going up in value.
Where Can I Trade?
There are an increasing number of brokers for you to choose from and each offers a similar experience. Two of the market leaders are TDAmeritrade and OptionsHouse and it is worth checking out either of these long established companies if you want an overall high quality service. If you are expecting to place many trades though, I would though recommend TradeKing as its prices are very low. A flat fee of just $4.95 for each options contract opened is charged which is cheaper than all of the other leading companies.
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