Options trading is an advanced stock investment strategy, but if you learn how it works you can substantially increase the amount of leverage that you have with your money. Rich Dad, Poor Dad author Robert Kiyosaki refers to option trading as the investment strategy of the rich.
Why is this?
Option trading simply gives you more leverage.
An option is a contract to buy a stock at a predetermined price. Stocks that have options available will usually have option contracts which expire on a monthly basis. Option contracts always expire on the third Friday of the month in the contract. For example, a July contract expires at the end of the trading day on the third Friday of July.
How does this give you leverage?
Let’s take a theoretical example with a fictional company “Poodlez.” A recent close price for Poodlez (POODZ) was $438.77 per share. If you wanted to buy 100 shares of Poodle, you would need $43,877. If Poodle went to $440.77 per share your total earnings on your $44,077 investment would be a mere $200 or a 0.4% return on investment.
Now let’s look at the Poodlez July option contract for $440 per share. Just like the stock price, option prices go up and down as well. Let’s say the July contract was available for $19.70 per share. If you bought this contract today you would have the right to buy Poodlez at $440 per share, between now and the end of trading day on the third Friday of July.
For the sake of this example let’s say that Poodlez goes to $470 per share. What you could then do is execute the contract with your broker. They’re setup to do this and will buy your Poodlez stock at $440 a share and sell it at the market price of $470 per share. The great thing about this is that you don’t need the $44,000 to buy the stock. The broker buys and sells it at the same time and you collect the profit.
By trading options you gain leverage over a stock that you possibly could not have afforded to buy outright.
There is a downside option trading.
Options are like buying ice cubes.
The moment you buy them, they begin to melt. In the above example if Poodle doesn’t go high enough between now and the third Friday of July to make you a profit, the option contract will simply expire and your investment will disappear.
A good way to think of options, if you don’t like the ice cube analogy, is that you are buying time.
While options can appear confusing they follow the basic rules of buying any stock. You’re buying a contract which gives you leverage over a stock so you should expect most of the fundamentals to be the same. This means that the research you do on a stock and its company before a trade still applies.
Investment houses usually require that you achieve a special trading status before trading options. Check with your broker to learn what those requirements are and study stock option investing as a smart addition to your stock investment strategy.
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