Why Option Trading Is My World?

Options trading becomes the in-thing and most trendy investment strategy nowadays. In fact, option is a much popular financial instrument especial in Asia lately. There was even an Options Trading Championship or competition being organized at Singapore, Malaysia and Indonesia concurrently in Oct 2007 organized by Freely Business School headed by Dr Clemen Chiang.

So, why options trading is so popular and in fact being viewed as a tool to attain financial freedom?

Generally, there are 4 main reasons we should consider options trading:

1. Limited risk and exposure
2. Hedging
3. Leverage
4. Generate additional income on existing portfolio

1. Limited Risk and Exposure

In options trading, buyers benefit from being able to control the movement in a stock for just a fraction of the cost of purchasing that stock. At the same time, we can never lose more than this modest dollar amount. Therefore, we can keep the bulk of the investment dollars in the safety of cash where it is immune to the wild and often scary swings in the market.

2. Hedging

One of the most conservative options trading strategies is to help protecting our investment portfolio against sudden downward pressure on stock prices. It is just like an insurance policy. Investors often buy puts as a hedge to protect their portfolio value.

For a comparatively and fairly minimal investment, through option trading, we can secure the right to sell our stocks at a particular price (a "put") regardless of how is the market doing.

By buying a protective put, an investor increases their break-even point of the stock by the cost of the put and if the stock price rises instead of falls, this strategy may limit the upside potential by the cost of the put.

The way this works is fairly straightforward. Let's imagine you decided to buy 1,000 shares of ABC Corporation for $88. To protect your $88,000 investment, you might consider buying puts.

Since each put controls 100 shares, you would need 10 contracts to protect 1,000 shares.

By choosing a strike price of $85 and an expiration date several months away, you would lock in the right to sell your shares with a maximum loss of $3,000 ($88 purchase price - $85 strike price x 1,000 shares) plus the cost of the puts.
Of course, the best scenario would be for the stock to increase in value so the puts would expire worthless. In either case, knowing that you'll be able to sell your shares at $85 -even if the stock drops to $50- might just help you sleep easier.

3. Leverage

For investors with a high level of risk tolerance, options trading enable us to use relatively moderate sums of money to leverage sizable positions.
For a fraction of what it would cost to purchase large blocks of stocks in high-flying volatile companies, investors can buy calls giving them the right, but not the obligation, to buy shares at a specific price (strike).

If a stock trades at $50, it would take $25,000 to buy 500 shares.
Through options trading, the same investor might buy ten 50 call contracts at $8. Now, for just $8,000 (10 contracts x $8 x 100 shares per contract), the investor owns the rights to buy 1,000 shares of stock at $50, any time before the call options expire.

If the stock price is $70 at expiration, the options will be worth $20 each ($70 - $50) or $20,000 (10 contracts x $20 x 100). The investor will have a profit of $12,000 on a $8,000 investment through options trading.

In contrast, the investor who paid $50 for 500 shares spent $25,000 to make $10,000 ($70 - $50 x 500 shares). That's the power of leverage.

However, the risks are equally high. If the stock doesn't move, the investor who paid $8,000 for the $50 calls will lose the entire investment. Likewise, the investors who bought the stock will have lost nothing because they still own the stock.

4. Generate Additional Income On Existing Portfolio

Another relatively conservative options trading strategy is covered-call writing to generate income on stock positions already held. Many investors use this strategy to help generate additional income from stocks in their portfolio or to lower the breakeven on stock positions being purchased.

This is can be done by selling out-of-the-money calls (i.e. options with a strike price that is above the current stock price). When we sell calls, we take on the obligations (if the buyers of the calls exercise their rights) to deliver the shares at a certain price (strike price) by a certain future date (expiration date). When selling options, we pocket the premium received from selling the options. Normally, the owners of the stock decide to sell calls when they think the stocks will stagnate over the short term. In this case, by selling calls generate income even if the stocks fail to stage a rally.

Here's how the strategy works:Let's imagine that you currently have 1,000 shares and the stock is trading at $67. If you sold 10 calls or less against the stock in your account, they would be considered "covered" because you wouldn't have to buy shares at the open market in the event of an assignment. For this reason, the position is far less risky than uncovered (naked) calls that, by definition, are written without stock as collateral.

If the $70 calls are trading at $3, you could sell 5 contracts and earn $1,500 ($3 x 5 contracts x 100 shares). Now, all you have to do is hope the stock remains below $70. If it does, you keep the $1,500 and all of your stock.
If the stock jumps to $72, you have two choices.

First, to keep the stock, you could buy the calls back. While this may result in a loss, from taxation perspective, this option could be preferable than incurring capital gains.

Your other option would be to wait for the assignment and sell 500 shares to the option holder at $70 per share. In this case, you still keep the $1,500 premium you collected from selling the calls. In addition, you capture the profit associated with the stock's move from $67 to $70 i.e. $3 x 500 shares = $1,500.

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