An option is a contract that allows you (as an investor) to buy or sell shares of an underlying stock at a certain price over a particular time period. Basically, there are two types of options. An option that allows you to buy shares over the defined period of time is called a call option, whereas an option that allows you to sell shares over the determined period of time is called a put option.
How to Trade Options
Let’s try to understand the basics of options trading with an example.
Assume a company is trading at $100 per share, and you buy a call option contract for that company at a $100 strike price (the price that is agreed upon at the time of buying the contract) with a premium (the price of the option contract) of $2. Buying 100 shares of this company in the open market would cost you $10,000. For a call option contract, on the other hand, you would have to pay $200 ($2*100).
For instance, if the share price goes up to $120 during the contract period, you would have the opportunity to make a profit. You could buy 100 shares at the strike price of $100 per share and sell it at the current price of $120 per share. So, you would make a profit of $1,800 when you deduct the $200 that you paid for the options contract.
In the case of a put option, you could make a profit by selling the shares at the strike price if the share price goes down. However, when you buy an option contract, you need to thoroughly research the company and its shares to make sure you’ll profit from the deal.
Benefits of Option Trading
You Could Make More Money with Option Trading
Suppose you buy 100 shares of XYZ company at $20 per share, and eventually, the price rises to $30 per share. Your purchase of 100 shares at $2,000 would yield you a profit of $1,000, so you would make a 150 percent return. But this return could go higher with options trading.
If you instead buy the call option contract at a strike price of $2 per share, you would pay just $200 for 100 shares. If the share price increases by $10, the value of the contract would accordingly increase to $1,000 as it covers 100 shares with a price increase of $10 per share. You could sell the contract at $1,000 since the price increased within the stipulated time period of the contract. So, your purchase of the contract at $200 gives you a profit of $800, a 400 percent return.
Simply put, if you purchase an options contract, you can never lose more money than the initial cost, no matter how low the price of the shares may go.
American call options contracts provide more flexibility than European call options. If you purchase one of these contracts, you can enforce it at any time before the expiration date, whereas European call options can only be enforced on the expiration date.