One way to boost the returns from the trading of securities is through the use of leverage. Leverage multiplies the gains to be earned from the amount of capital you deposit into a trading account. Trading stock options can provide significant leverage on changes in stock prices. Using this leverage correctly allows a trader to generate very attractive profits from a relatively small trading account. Options trading may be appropriate if you want to avoid breaking your new household budget but still want to use trading as a way to earn money.
Options are derivative contracts that take their value from the share price and volatility of a specified underlying stock. Call options give the option buyer the right to buy the underlying shares for a specific price and put options give the right to sell the underlying shares at a set price. The share price at which an option can be exercised is called the strike price. Options have expiration dates on the third Friday of the expiration month listed with a contract. A stock will have numerous call and put options trading against it with a range of strike prices and expiration dates. The basic theme to remember is that call options increase in value if the underlying stock goes up and puts become more valuable if the stock goes down.
Leverage on Stock Price Changes
The cost of an option contract is much less than buying shares of stock and the option will change value at a similar rate to the stock. For example, a specific stock is trading at $100 per share. A call option with a strike price of $100 has a price of $5. Since the option gives the option buyer the right to buy the stock for $100, for each dollar the stock moves above $100, the option price will gain about $1. If the stock climbs to $110 -- gaining 10 percent -- the call option will be worth at least $10, a 100 percent gain for the same share price change. The more the stock price changes, the greater the leverage provided by buying an option contract. Put options provide profits in the same manner as the stock share price drops below the option's strike price.
Option Pricing Specifics
The price of an option is based on the relation between the strike price and the time until the option expires. If the stock share price is above the call option strike price, the option has intrinsic value equal to the amount the stock is above the strike price. Any additional value in the option price is a time premium. The time premium will decay to zero at the expiration date. For an option trade to be profitable, the stock price must move past the strike price -- above for calls or below for puts -- by the amount of time premium paid when the option was purchased. If the stock is on the wrong side of the strike price -- below for calls, above for puts -- at expiration, the option will expire without value.
Option Trading Considerations
You can trade options using a stock brokerage account that includes options trading authorization. Each option contract is for 100 shares of the underlying stock, so the cost of an option is 100 times the price. For example, if the contract price is $5.00, one contract will cost $500 plus broker commissions. It is not necessary to wait for the expiration date of bought options. The options can be sold before expiration to lock in a profit or minimize a loss. The maximum loss for purchased options is the amount paid for the contracts. Another trading tactic is to sell options to collect premiums as a form of income. Selling options is a higher risk tactic because, as the Options Industrty Council notes, the seller -- or "writer" -- has "no control over whether or not a contract is exercised." The key to successful leveraged options trading is to select stocks which will move by a significant amount up or down and then buy call or put options with enough time until expiration for the stock to make the forecast value change.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.