Option trading explained: What is option leverage?
1- When Delivery is Made |
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Delivery Now |
Delivery in the Future |
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| 2- Rights of Parties | Equal Rights | Stocks |
Futures |
| Different Rights | Options |
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Options
So stock trading and futures trading differ in when the delivery is taking place. Stocks for delivery now and futures in the future. What about stock option trading then? Options are also contracts for delivery of something in the future. So in this respect stock option trading and futures trading are similar. Now for the big difference. With futures contracts the seller has to sell and the buyer has to buy. The deal is fixed, both have equal rights and no one can back out. In option trading the buyer has a choice. He can choose if he wants the deal to take place of not. The seller has to do what the buyer wants. Yes, it’s an unequal or asymmetric agreement. Now don’t use the word asymmetric around traders cause it sounds very academic. Off course the buyer has to pay for the privilege to choose. This payment is the option price.
In stock option trading the buyer at delivery date chooses if he wants to do the deal or not. To choose to do it is called to exercise the option. For that reason the delivery date is also known as the exercise date. Options which gives the buyer the right to buy the underlying are called calls. Options which gives the buyer the right to sell are called puts. Yes, you actually buy the right to sell. This means that there are four different sides you can be on in stock option trading. With futures you either buy (long position) or sell (short position). With stock options you can buy a call (go long calls), sell calls (go short calls), buy puts (go long puts), or sell puts (go short puts). If you buy puts or calls you have the right to choose at the future date. If you sell puts are calls someone has the right to choose and you have to do what they choose. The buyer of the option can’t loose more money than the actual premium. If a stock option trader buys an option and the price of the underlying goes the wrong way the trader simply throws the option away. The seller can loose a lot of money if the price of the underlying moves a lot in the wrong direction. Brokers ask you to put up a margin for selling options but not for buying. For buying options you just have to have enough money to pay the option price.
Example
An option trader expects the price of Microsoft stocks to go up from 50$ to 60$. His friend the stock trader is of the same opinion and buys 100 Microsoft stocks at 50$. The option trader instead buys Microsoft call options for 5$. The call options have a strike price of 55$. This is the price that stocks will be delivered for in the future. The option trader can afford 10 times as many of these calls as of the stock, as the calls cost only 1/10 of what the stock costs. He invests as much money as his friend and buys 1000 calls.
If the trading friends are right, Microsoft goes to 60$. The option trader then exercises the calls to buy the stocks at 50$ and in the same second sells them to a stock trader for 60$. This way the option trader makes 1000*10$=10000$. He paid 1000*5$=5000$ for the calls so the profit is 5000$. The stock trader sells his 100 stocks for 60$ and makes 100*10$=1000$. A 20% return for the stock trader compared with a 100% return for the stock option trader. This is called leverage and the reason why many option traders love option trading. What would have happened if Microsoft had gone down to 40$? The stock trader would have sold the stocks for 40$ and lost 100$*10=1000$ or 20%. The option trader would not have exercised the calls as buying for 60$ when the market price is 40$ would be outright stupid. The calls would have been worthless and the stock option trader have a 100% loss. So never ever trade options with money you can’t afford to loose. You have to consider the possibility of losing all money you invest in options. That is not at all unusual. Stock option trading is exciting because the leverage is so powerful, but only put a small part of your savings into stock option trading. Next we'll look at a neat tool for visualizing stock option trading positions: payoff diagrams.