Option trading explained: What is option leverage?
On this page you'll learn option trading strategy to leverage a trade in stocks. First an introduction to stock options by comparing them to stocks and futures. After that option leverage is explained.
Options, futures and stocks are all exciting instruments to trade but they differ from each other in two ways.
1- When delivery is made
2- The rights of the contract parties
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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This page consists of three parts: Futures, Options and an Example. I will explain stock option trading to you starting with the difference between a stock and a future and then continue to the difference between a future and an option. This way we will move from the equal rights/delivery now field in the table via the equal rights/delivery in the future to the different rights/delivery in the future field. This sounds confusing now but when you have been through this tutorial, stock option trading will sound very simple to you.
The first thing for understanding stock option trading is understand what a future contract is. Futures are simply contracts for deliver of something in the future, the delivery date. Pork belly futures are of course contracts for delivery of pork bellies. In option trading what will be delivered is called the underlying. The underlying of a pork belly future is pork bellies. If I buy a pork belly future today I have entered into a contract to buy pork bellies on the delivery date. The price I have agreed to buy the pork bellies at is known as the futures price. I don’t have to pay this now. I pay it on the delivery date. So you can enter into future contracts for free?! No unfortunately you can’t. Your broker will require that you put up collateral for the contract to make sure no one in the market bails on their commitment. This collateral is known as margin. The margin amount is usually much smaller than the futures price. So even though you can’t enter into futures contracts for free, you don’t need a whole lot of money to trade. You can see that there is a time difference here between stocks and futures. Stocks you buy straight on the spot. Right now. Futures are contracts for buying at some other time. If you sell a future, or “go short” in trading lingo, you enter into a contract to sell at a later date. In your option trading you will not sell actual pork bellies at delivery date. You don’t have to get a bunch of pigs to sell to the buyer of the contract. You just buy a futures contract in the market to close out your short position. Preferably with a handsome profit. Look at the table again. We have now completed the move from the equal rights/delivery now field to the equal rights/delivery in the future field. Let’s move on to look at what you came here to learn. Stock options, contracts were the parties have different rights.