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Options Trading - Basics of Options Trading Explained

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  • Options Trading - Basics of Options Trading Explained

    Option trading gives us huge amounts of leverage. Think of a water skier behind a boat all the boat driver has to do is turn the wheel slightly and the skier is flung past the boat at a rapid pace or leveraged past the boat. So in the technical sense leveraging means using a small effort to move a large object.

    Looking at it from a financial sense, leverage is having control over a much larger investment or asset, or gain a very high return using a small amount of money. From my own experience the uneducated use, or abuse of leverage can be risky. In fact, Any investment strategy carries a great risk if you don't know what you are doing. Your "risk" when trading any Stock Market means the probability of a donation (loss) of your trading capital. A common misconception with Option Trading / Stock Options is that their use carries a very high risk. Actually Stock Trading can carry a greater risk...let me explain why.

    Leverage - What you need to remember with Option Trading / Stock Options is that they allow you control over the same amount of shares using small amounts of money than you would need to buy the actual stock. Obviously this is the leverage we are talking about. However consider this... When you are Options Trading, you risk a much smaller amount of money for the same quantity of the underlying stock, so in actual fact if you were to buy the stock outright, your risk would be considerably higher!

    Here's an example...if XYZ shares (my favourite stock) was currently trading on the ASX at $30.00 and a Jan $30.00 Call Option costs $ 1.60, we could buy 1000 shares of XYZ for $30,000 or we could spend just $1,600 on the May $31.00 Call Options. By purchasing the Call Options, you would still control the profits on $ 30,000 worth of XYZ shares, but the maximum you would stand to lose is only $1,600 compared to the whole $ 30,000 if we were to buy the actual shares.

    Leverage becomes dangerous when we decide to risk the whole $30,000 in Stock Options, and is one of the biggest mistakes made in Options Trading. When using the power of leverage with Stock Options Trading there are various ways to reduce your risk, depending upon which strategy you choose to use, and your discipline to follow money management rules. Short selling - There is really only one way a Stock trader can make money in a down trend, and that is to "Short Sell" a stock. This is the process of selling in advance, stocks that you do not own, with the assumption that the stock price will continue to fall. This exposes the trader to an unlimited amount of loss should the stock rally all of a sudden, resulting in margin problems.

    As an Option Trader, you could simply buy put options to profit from the same drop but limit your potential losses to only the price of the put options. For example....if XYZ shares were trading on the ASX at $30.00 and a Jan $30.00 Put Option costs $ 0.80 then buying 1 contract of Put Options would expose you to a maximum loss of just $ 800 if the stock price should rise to $ 35. However if you were to short sell the same shares, your maximum potential loss, would be $ 3,000. One Direction - When you trade the stock, you either make money when the stock goes up or when it goes down (when you short sell) but NEVER in both directions at the same time. In options trading however, there are strategies that allow you to profit from BOTH up or down moves, as well as when the price trends sideways. If you can profit from any direction, then the higher your chances for profit and therefore the lower the risk. I will show you in another article the covered call strategy.

    Hedging - Hedging is the practise of insuring against risk. With Stock Options you can take a position to offset the risk in another. When you trade Stocks, the only way to hedge your position against risk is to manage and diversify your portfolio. When trading Stock Options, you can not only manage and diversify your portfolio, you can also hedge options with options to minimize your potential losses, and even hedge, or insure stocks with options!

    Stock options are a far more advanced financial instrument than stocks themselves, and they can allow you to profit regardless of market direction or conditions. But just as you face a potentially high risk if you drive a car without a safety/seat belt, if you don't obey the rules when using leverage and trading Stock Options you expose yourself to the same possibilities. However, when leverage is respected and used properly, Options Trading can be safer than Stock Trading.


    Article Source: http://EzineArticles.com/3630053




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