How Options Trading Works
The buying and selling of contracts which provide investors the right to buy or sell stocks or other assets is the definition of options trading. To those unfamiliar with contracts that may seem like a mouthful so we'll break it down a bit. Even though the option price quotes you may see in the paper on any given day may appear to be the same as stock price quotes they convery entirely different information. Each contract price quote you see will define when you have the right to execute the contract, how much you will pay when executed, and which security will change hands at the time of execution. By now you should have a sense that an option contract conveys information about a potential transaction in the future.How Options Trading Is Effectively Leveraged Trading
The reason that trading options is leveraged trading is that an investor who buys a contract does not need to have the cash on hand necessary to fulfill the contract. Consider a simple example:A trader with $1000 in his account goes into the market and buys an option on Apple stock for $2.00/contract with a strike price of $385/share. Contracts convey the right to buy 100 shares typically, so our trader pays $200 (plus a commission) to his option broker to secure the contract. How much buying power (in dollars) has his option broker given him?
The answer is that our trader has effectively $38,500 of buying power courtesy of his broker. Not too shabby for a trader with only $1000 in his account. How can this be? This is essentially a form of margin trading, whereby the broker vouches for your account's credit-worthiness. How can that be? Conside what happens when things go wrong.
How Your Option Broker Works When Your Options Trades Execute
Now bear in mind 99.999% of all contracts NEVER get executed (they are usually sold before execution or expire worthless - but this hypothetical case CAN happen), but in the odd circumstance they do, you can see exactly how your margin credit with your option broker becomes effective in real terms rather than in effective terms.In our case before, our adventurous trader bought a option on Apple stock with a strike price of $385. Imagine then that on the date of expiration that contract expires in the money (ie Apple stock price is higher than $385) but for whatever reason the trader fails to sell the contract at the end of the day for a profit. MOST brokers automatically execute in the money options contracts - securing the shares from the trader (or other broker) who owed the shares at execution - paying/fronting the $38,500 on our trader's behalf, and thus would come looking for $38,500 from our trader's account. Unfortunately there is only $800 left in the account (remember we spent $200 of our original $1000 to buy the contract in the first place). At this point the trader is in a heap of trouble, having caused a trade to fail. The option broker would have no choice but to default the account and place what is called a margin call - taking control of the account and selling assets into the market in whatever manner they so choose so long as they follow the terms in your margin account (believe me, they don't favor you in the case of a margin call).
Options Trading Is Still a Great Way to Trade
Hey I don't mean to put off anybody to options trading, but it behooves you to understand how your option broker sticks his neck out for you and makes it possible for you to really amp up your buying power (and potential for big returns) in the stock market.Happy Trading!
