Stock option trading is a great instrument for short to medium term investing, some option contracts such as LEAPs (Long Term Equity AnticiPation Security), last as long as 3 years.
The good thing about investing with stock option contracts is that it allows you to control a given number of shares of the stock, at a fraction of the price. Also options have a much better risk – reward ratio.
Unlike the simple, dollar for dollar pricing structure of most trading instruments used to invest in the stock market, stock options are more complicated and are affected among other things by volatility (How much the stock fluctuates up and down).
Stock Option Trading Requires A Good Look At Volatility
As you can see on the above chart showing both stock price and option price movement, the option follows the stock price as it moves higher, but at some period in the middle of the chart, the stock just fluctuates up and own in a range, causing the option to continue to rise! So even though the stock didn’t actually rise for weeks, its options did rise just because volatility rose!
The good thing about options trading is that it offers extreme versatility and many ways through which you can trade specific stock market trends, limit risk or even completely remove risk (stock market arbitrage).
Stock Option Trading With Minimal Capital
With stock option trading, one can make investing in the stock market extremely affordable, imagine that a stock trading at $100, would require you to commit $100,000 in order to buy 1000 shares of it. On the other hand, its in-the-money Call options may be priced in the range $8 to $15. The deeper in the money, the more expensive the option is, and the more it will move dollar for dollar with the stock. If you pick 10 Call option contracts of the $8 premium, you will pay $8,000 where 10 contracts of the $15 Call options will cost $15,000.
Which option is best, it really depends on the magnitude of the expected stock price movement. If you believe the stock will only move a couple of dollars higher from $100 to $102, then the deeper in the money options will make you more money, outer of the money options require more stock price movement to make as much money.
Look at the profit table below (Underlined figures are projected profits):
As you can see with the stock option trading scenario above, in the case of a $2 move I would rather buy the $8 Call option, but in the case of the $20 move, I would buy the $15 Call, where I would commit $7,000 more, but I would also make $5,000 more profit! The $5 move is debatable and can be traded with either type of stock option depending on the money you can afford to commit.
Stock Market Investing Strategies and Stock Market Speculation by..
Scott Smith
Invest In The Stock Market © 2008 – 2010
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