Three Way to Use Options

This will introduce the three main options strategies:

• speculation
• income, or protection
• the advantages and disadvantages of each
  

 There are two kinds of options, calls and puts.

The first strategy we'll look at is speculation. Usually when a trader buys a call or a put, he is speculating on the stock price. If you think a stock is going to rise, you'd buy a call. If you think the stock is going to fall, you'd buy a put. The advantage of speculating with options, is that it allows you the potential to profit from a securities price movement with a small initial investment for the option contract. However option is significantly riskier than a stock. For example, let's say you're bullish and want to buy a particular stock. Because the stock is trading around $670 per share, purchasing 100 shares would require you to invest about $67,000. However, you can purchase a call option for the same stock for significantly less. Fro example, one contract recently traded for $19.90 per shares. This means purchasing the contract allows you to control 100 shares of stock for $1,990, plus commissions and fees. Obviously, this is far less than the stock's $67,000 price tag. The ability to control a lot of shares with less money, is known as leverage. Let's see how leverage works with options. For example, using the stock from before, let's assume that its price increased $10. The stock price increased from $670 to $680 resulting in a 1.5% return. Now compare this to changes in the option price. A $10 stock price increase pushes the option price from $19.90 to $29.90, for a gain of approximately 50%. $19.90 to 29.90, for a gain of approximately 50%. This is a pretty incredible return, and usually the reason why traders are drawn to options. However, what would happen if the stock fell? As shown here, a drop in the stock price resulted in a 1.50% loss on the stock, which is unfortunate but most investors can probably live with it. However, the impact on the option price is stunning. This $10 stock price change caused the option price to decrease nearly 50%. Another advantage of options, is that they allow you to trade in any market condition, even sideways markets. income-oriented investors can use options as an avenue to create income, and are usually less concerned about the underlying stock moving. In our previous example, the speculator purchased an option for a certain price. This means the option seller collected that price. When the stock went up, the option seller lost money. When it went down, he made money. selling options in sideways markets allows an investor to create income. 

Now on to the third strategy, protection. Investors may purchase put contracts for a particular stock. This is because puts allow investors to sell their shares at a certain price if the stock falls. As you can see, there are a lot of ways to use options. Options can be used for speculating, creating income, or protecting your portfolio. As you lean more about options, you'll discover which strategies best fit with your investing goals.