Welcome to our Options Trading Tutorial. Options trading is all about understanding leverage and trying to get the highest return investments to pay out in the shortest amount of time. You'll find that in this tutorial we delve into other related topics where leverage is important in order to improve your understanding of why options trading in most cases offers a better trading experience than other forms of trading.

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Options Trading Basics | Call Options | Put Options | Carry Trade | Inflation Investments | Option Brokers | Making Money on Options
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Saturday, May 15, 2010

Cash Is King for the Options Trading Icon

In options trading Rule #1 is: Cash - IS - King

Sums it up, doesn't it?  Why is it that such a simple concept get so easily lost amongst day traders.  Aggressive and smart people are humbled over and over again by the market.  WHY?

Simple: Because they forgot rule #1: Cash-IS-King

I have seen far too many traders get greedy and take on positions far larger than their ability to manage or properly capitalize with COLD-HARD-CASH.  Why is it that traders insist on getting greedy and either abandon their established trading limits or simply fail to establish good limits at all?  Does the average day trader forget that there are bigger fish in the sea who can easily take out weaker leveraged positions?  Face it, unless you have huge amounts of capital to work with, margin-style leverage is only going to get you completely wiped out.  Leave the margin trading for the big fish.  The good news is you don't have to use margin to create leverage.  It is really possible to leverage your buying power with options, paid for with CASH.  Have I mentioned Cash-Is-King?

Consider the example of a forex margin account.  A typical forex margin account (like here) will allow you to trade using up to 400:1 leverage (on maintenance margin after initial 200:1 margin position).  Sounds great doesn't it?  A one cent change in an exchange rate turns into as much as $2 in profit per dollar of capital invested.  Where's the problem in that?

The Devil In Margin Trading Is the Margin Call

What is a margin call?  Think of it as catching a big wave on a surf-board and then finding out you're actually riding a tsunami into the ground.  The math isn't all that complicated but the gist is this: the same rules that apply to gains in a margin account apply to losses as well... except for one thing.  If your trades are going badly and your equity (cash + net securities value) falls below a certain level (called the maintenance margin), your broker can (legally and without notice) begin selling any and all of your positions to satisfy margin requirements.  Basically, they can wipe out your entire account... AND if the position has gone badly enough, you may still have unpaid losses!

Ok So Margin Trading Isn't All Peaches and Cream - How Do I Create Leverage Using Cash Options?

Now you're starting to ask the right questions.  A lever, from the time of Archimedes to the present, has always been a tool for a person to do more work than can be done using the body alone.  A lever in day trading stocks allows a trader to purchase or control vastly more buying power than they would otherwise be able to get with cash alone.  We've already discussed how this is done with margin (a margin stock account allows 2:1 leverage max).  Another way to create leverage is by using cash stock options.

How Do Cash Options Create Leverage?

A stock option is defined as the right to buy a particular stock on or before a specified time for a specific price. An option is a CONTRACT between the buyer and the seller of the option.  The SELLER of the option is paid a PREMIUM for the risk exposure they are taking in committing to being the short side of the contract.  The premium paid by the buyer of the contract relative to the actual share price of the underlying stock determines the leverage.

Think of it this way - a person with $1000 can buy 100 shares of a stock that has a share price of $10/share.
An options trader on the other hand might be able to buy 100 call contracts (a call contract typically represents right to buy 100 shares) for $0.10/share ($10 per 100 shares) giving the trader right to buy (control) of 10000 shares.  This represents buying power leverage of 100:1 versus an outright cash stock purchase. 

Now who knows what the terms of the strike price and expiration date are of the options contract.  That's not the point here.  The point here is to demonstrate that options create buying power leverage for the cash options trader (long side).  The seller of the call contract(s) is a different matter entirely.  They may be closing out a position, hedging a position they already have, or making a (naked) gamble that the stock will go down and they'll never have to pony up the actual shares of stock.

I hope you can now see why options trading using purchased cash options is the small capital trader's way to create leverage - remember rule #1: Cash-Is-King.