Attracted by large portfolio gains, and the desire to earn increasing amounts of passive income, many individual investors are firing up their computers and going online to start learning options trading strategies.
As you may, or may not know, an option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a certain price on, or before, a certain date. The seller, in return, agrees to sell or buy the asset should the contract be exercised by the owner. In return for selling this right to a buyer, the seller receives a premium which is based on numerous factors such as time to expiration, intrinsic value, and so on.
While this may sound confusing at first, it is much easier to grasp when you see an example.
Lets assume that SCC company is trading at $10 per share on the stock market. From your market research, and based upon a few positive comments made from analyst that follow this company, you expect the price of SCCs stock to be much higher in the next few months. In order to capitalize on this opportunity, you decide to buy one option contract to buy the stock at $10. Since the strike price is right at the current price you could easily expect to pay $100 for this contract. Options contracts are sold in lots of 100, so if you buy or sell one contract you are essentially buying or selling the right to control 100 shares ($1 per share * 100 shares).
If the price of SCC stock increases to $18 at the expiration date, you have the right to buy the stock from the seller at $10 per share. In this circumstance, many investors will simply purchase the stock then immediately sell it on the open market pocketing a cool $700 profit [($8 price increase – $1 premium paid)*100 shares].
If the price of SCC stock remains at or below $10 per share your option has expired worthless. The seller gets to keep the premium you paid and the stock and you lose your entire investment of $100. For this reason, when you are learning options trading it is much safer to stick with selling covered calls.
As small investors continue to face 1% fixed income returns and flat, or even decreasing, dividend yields, learning options trading has become much more attractive. Before you rush out and invest your hard earned money it is always a good idea to practice via paper trading until you are completely familiar with all of the risks and benefits associated with option trading strategies.