You are an experienced stock trader, comfortable in you skin, so why should you care about how to trade options? In a word – leverage.
AAPL is trading at 172.50. You estimate that AAPL could move to 180 in the next month. You buy a round lot (100 shares) for $17,250 and sell all 100 shares a month later at the expected price for $18,000. You have a profit of $750 or a gain of 4.35% on the transaction (we are ignoring transaction costs).
The option trader with the same expectation buys the 172.50 strike price call option contract with a month to expiration for $415. At the end of the month he exercises the call option to buy 100 shares of AAPL for $17,250 and immediately sells the same shares for $18,000. The option trader’s profit is $750 – $415 or $335. Here is the kicker. The option trader’s profit gain in this hypothetical idealized example is 80.72%.
Also, depending on the brokerage firm and the type of account, the stock trader’s buying power was reduced by as much as $17,250. That could have prevented the stock trader from taking advantage of other opportunities he saw in DIS or NKE. The option trader’s buying power reduction was exactly the amount he paid for the call option – $415. Even with a small account size the option trader had funds available to act on those other opportunities that the stock trader might have been forced to pass on.
Leverage means more than the opportunity for higher percentage gains, it also means leveraging your account buying power to act on a greater number of different opportunities, or even to buy and sell (the equivalent of) 100 share lots of underlying assets like AMZN or GOOGL with a share price greater than $1,000. In a cash account a round lot of a $1,000 stock is $100,000. For lots of stock traders that is not a problem, but for the rest of us…we use options leverage.
There is more to stock options trading than the benefits of leverage. Risk management compels us to see leverage as something that cuts both ways. In the above example if AAPL had stayed stuck on 172.50 for the month the stock trader would have lost nothing. The options trader would have lost $415 when is call option expired, or 100% of his investment in that transaction.
Return –> Swing Trading