Traded Options a way to Make Spectacular Profits

Options are contracts which represent certain rights that are dependent on the price of an underlying asset. They come in many different varieties, but the most common are vanilla stock options. Vanilla options are one of two types: puts or calls. Besides vanilla, there are exotic options, but these are much less commonly traded.

A call is a contract to purchase some amount of an asset once a certain price has been exceeded. In our examples we will assume shares of stock. Each option, whether a call or put, is defined by two characteristics: the expiration date and the strike price. The expiration dates are typically once a month. Some companies offer intraday options, while others allow you to set just about any expiration you desire, but a standard stock option expires the third Saturday of some month. The strike price is simply the price the owner can purchase the asset at. Since an option contract represents one hundred shares of stock, what this means is that if the strike price is exceeded then the buyer of the call has the right to purchase one hundred shares of stock from seller at the strike price. He can then immediately sell this back at stock’s current price, netting a profit. For instance, if an investor purchased a call option for Microsoft with a $30 strike price, but Microsoft was trading at $35 at the time of expiration, he would net $500. That’s $5 per share for one hundred shares. The individual that sold the option would owe $500 at expiration.

A put is the opposite of a call, representing the right of the buyer to sell someone stock at a predetermined price. In this case the seller of the put is obligated to purchase the stock if it falls below the strike price. If in our example above the buyer had owned a put then it would have expired worthless and the seller of the option would have kept the premium he originally received. It should be noted, however, that option do not have to be kept until expiration; they can be bought and sold throughout their duration just as stock can.

While options are often used as a hedge for portfolios, to protect against market downturns, there is usually a speculator on the other end of every trade. Many traders and investors are drawn to options due to the high amount of leverage they can provide. Often options are relatively cheap when compared to buying an equivalent amount of stock, so allow an investor the opportunity to profit greatly from movements in the underlying. For the purchaser of an option there is limited risk (the premium paid) and unlimited profit potential. For the seller there is limited profit and unlimited risk, but often the probability is in their favor and the options will expire worthless.

Options are priced according to a number of factors, but the two major components are time and volatility. The longer the duration and the more volatile the stock, the greater the price. The distance of the price to the strike price also determines the options value. Tremendous profits can be made when cheap options are bought close to expiration and far from the price. An investment of a few hundred dollars can easily turn into thousands if the stock price moves significantly.

There are many ways that people trade options, combining different types into endless strategies. For example, there is an option strategy called a ratio write where two or more options are sold at one strike price while simultaneously a fewer number are bought at a strike closer to the stocks current price. This is usually done because the investor believes that the stock price will move in that direction, but not very far. Selling the two options provides the money to purchase the other.

The world of options offers investors and traders many advantages, but the risks must be known as well. For a savvy individual though, they provide some of the greatest opportunities for an individual to leverage their money into large gains far exceeding that possible through the purchase of stocks. Before you begin be warned that to properly understand these investments requires a large investment of time and patience, but the payoff can be spectacular.