Their is a whole world out there called stock and option trading. Some traders or investors trade stocks, others trade options, and some trade both stocks and options. We are going to begin by explaining some of the basic differences between stock and option trading. Trading options can give you a tremendous amount of leverage over trading stocks. There are all kinds of different types of options. On the US stock market one option contract is equal to 100 underlying shares. This means that an option trader can profit with a small amount of money because the option contracts that he purchased represent a very huge underlying stock position.
If the option trader wants to buy only 1 option instead of buying 100 shares of a particular stock, he will also be limiting his amount of risk. On the other hand, trading options can also be very risky because they expire at a specified amount of time. If you decide to trade options you have the potential of increasing your profits in a very short period of time, but you can also lose a lot of money. You may even lose your entire initial investment if you don't trade with a specific strategy or use a proven system that works.
We are going to describe a couple of scenarios that will demonstrate some of the advantages and disadvantages to both stock and option trading. Lets say that the stock ITW (Illinois Tool Works) is currently selling at $50. As a trader you have done your research and technical analysis that convinces you that the stock ITW should be able to reach $55 in the near future. You have a few alternatives. You can either purchase 100 shares of ITW at the price of $50, which will cost you $5,000. You could also buy a large number of call options for $5,000, or you could buy 1 call option lets say for $200, that represents 100 shares of the underlying stock. For the purpose of explaining the differences between stock and option trading we are going to purchase both 100 shares of ITW that will cost us $5,000, (not including trading fees) and also 25 February calls at the strike price of $52 , which also costs us $5000 (not including trading, and option fees) . These February calls,have an expiration date which is specified, exactly 3 months away from today (day of purchase). These options that we purchased cost us $200 per option. The stock ITW must reach at least $52 before expiration in order for me to break even. In the first scenario lets say that the stock ITW really goes to $55 as we predicted before February's expiration date. If this were to happen, our 100 shares of stock of ITW that we own, will have made us a $500 profit. This is because our 100 shares which we currently own are now worth $5,500, because the price of the stock ITW went to $55. However with the call options that we purchased that also cost us $5,000 we made $7,500! How is this possible? Its simple, we were willing to pay $200 per option, in the strong belief that the stock should go above $52 within the next 3 months. The stock went to $55, the difference between $52 and $55 is $3, but each option represents 100 shares so we multiply 3 by 100, and that equals to a $300 profit on each option we bought. We bought 25 options, so we multiply 25 by 300 which equals $7,500. In this scenario we can clearly see how buying the options were far more profitable than just buying the underlying stock. Now, lets describe another scenario, our stock ITW stays at $50 and only 4 months from the purchase date the stock goes to $55. Here our February options that expire in February are worthless. We lost $5,000 with our February options, but with our 100 shares of stock we purchased we still made a $500 profit but it took us 4 months till we made our profit. Here in this second scenario we can see how risky option trading is compared to stock trading. Now, here is a third scenario which will demonstrate how trading options can also be used to limit your risk from severe loss. Lets say you bought 100 shares of stock ITW for $5,000, and 1 February call, that costs you only $200.(represent 100 underlying shars of ITW ).The stock ITW then goes down to $40. Contrary to your prediction of continuing its uptrend , ITW starts declining in price rapidly (crashing). Your February option expires, and you lose your initial $200 investment. Your 100 shares of stock that you purchased for $5,000 are now worth $4,000. Oh Boy! You lost $1,000 already on your stock investment, and if you don't sell them now you could theoretically lose your entire $5,000 investment. In this scenario you can see how option trading limited your risk compared to stock trading. When the cost of the option you bought was $200, there is a guaranteed limit of how much you can lose, which is only $200. This is not the case with stock trading. If you invested $5,000, than your potential risk is $5000.
Every trader and/or investor must consider before trading stocks or options which strategies he wants to adopt and determine the amount of risk which he is willing to expose himself to. Both stock and option trading have their advantages and disadvantages. Always remember that more risk can increase your profits but can also lead to greater losses.
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