Option trading provides a unique way to leverage the price moves of the market. Never has this been more apparent than in the last few weeks. To clarify some of the differences with trading in actual stocks, try to remember these two crucial points. As an option trader, you make money by purchasing the “right” to buy or sell an equity, and that right in itself has value and gives you, the trader, leveraging power. You will never need to worry about finding an interested buyer; through the option contract itself, the sale is guaranteed the moment that you decide to sell, providing you have purchased an option with a level of open interest.
Most of us are accustomed to thinking of the stock market as an exchange in which you buy and own actual shares of stock, and then decide to sell for various reasons. Therefore, it sometimes requires a new mindset to fully appreciate the value of an “option”.
The option premium is the amount you pay to control the underlying equity. This option premium increases in a magnified way when compared with the underlying equity price: As the equity’s price goes up, the value of your option also increases. Then you sell your option to someone else, well before the option’s expiration date. In that way, you trade the options, but never actually buy or sell the underlying stock.
If you buy an option on a stock, you can think of the option as a “down payment” on that stock. Imagine purchasing an option on 100 shares of American Express stock to control the financial power of those 100 shares.
To make this even more clear, let’s compare a stock purchase to an option purchase.
If American Express’s (AXP) stock price is $90 per share, 100 shares of stock would cost $9,000. If next month, the stock price goes up $2 and you sell the stock, you have a profit of $200 on your 100 shares. Your profit is just over 2.2%.
However, if you buy a Call Option on those same 100 shares of AXP stock, you will pay approximately $2.50. (This is a good estimate, but the actual option prices vary greatly). This $250 controls all 100 shares of AXP stock.
If American Express’s stock price goes up $2, your option may also go up $2. (This varies according to the underlying option).
This $2 increase or $200 profit is 80% of the initial price you paid for the option. Using the leverage of options, you’ve made 80% profit on the same underlying equity (stock) that only realized (gained) a 2.2% profit when the actual stock was sold.
- 100 shares @ $90 = $9,000
- $2 increase x 100 shares = $200
- New Value = $9,200
- Gain 2%
- 1 Option contract on 100 shares @ $2.50 per share = $250
- $2 increase in option price x 100 shares = $200
- New Value = $450
- Gain 80%
I don’t know about you, but I will take an 80% gain over 2.2% with a smaller capital outlay every day. It is evident that options provide traders with two benefits. You can begin trading with a small amount of money. You can turn a high percentage of profit. Sounds great, right?
As you begin to practice trading, your confidence increases, and you can earn even greater profits. With careful, precise trading, a $200 profit can become $400, $400 can become $800 and, before long, a trading account will increase, showing exponential or “compounded” profit.