The Benefits of Trading Contracts

First of all an Options Contract is a derivative of a stock. So, we have to remember that we are dealing with a derivative here. One options contract gives the owner the right to buy or sell 100 shares of the underlying stock within a given period at a fixed given price that is pre-determined. That statement may sound confusing and so we will clarify with an example. Apple is one of our favorite stocks, so we will use the example of AAPL, which is Apple, Inc. stock symbol. Let us assume that AAPL is trading at $200 in the stock market at this time and we think that the stock price will go up by around 10% when the next quarterly earnings are released which is 6 weeks from now. We could buy the stock at the $200 per share and expect the stock price to appreciate by 10% to $220 in the next 6 weeks. That would be a good return. We could also buy the $200 strike price call options contract that will expire sometime after the earnings release by paying a premium. Depending on the volatility of the market at the time, the premium that we would have to pay would vary. But the premium would be for us to have the “option” to buy the AAPL stock at $200 after the earnings release. In other words the choice is up to us whether we eventually buy the underlying stock or not. Remember that one call options contract gives us the ability to control 100 shares of the underlying AAPL stock. So, for instance, if we paid a premium of $1000 for buying the option, we are effectively controlling 100 shares of AAPL by making a down payment of only $1000. As opposed to that to buy 100 shares of AAPL at $200 per share, we would have to make a down payment of $20,000 or whatever margins our broker would allow.

Therein lies the first and biggest advantage of trading options contracts. Leverage! Also, look at it another way. We have bought the call option contracts for a strike price of $200. That is also called as an at-the-money options contract because the strike price and the current price of the stock price is the same. From now on, any increase on the stock price will typically mean an equivalent increase in the options premium as well. In other words, if based on earnings expectation, the stock price of AAPL starts going up; the premium on the call options will also go up more or less equivalently (since the option is at-the-money). That would also typically mean that if the stock price goes up to $210 real quick, we may end up doubling our money. How is that? We bought the options contract at a premium of $1,000 or $10 per share ($1,000 divided by 100 shares). If the stock price goes up to $210, the premium will likely go up to $20 and we can decide to sell the options contract back in the market at the higher premium. Thus we will end up making a 100% gain within a short few weeks. Trading the stock directly would have given us only a 10% gain. That is the power of leverage, which can be generated trading contracts.

The biggest misconception out there is that options contract trading is a high-risk venture. That is not necessarily true. Depending on how one plays it, options contract trading actually offers significant risk mitigation. Leading along with our example above. Let us assume now that our forecast for the AAPL stock price was wrong. Instead of going up by 10%, the stock has gone down by 10%. In this situation, the risk for the options contract trader is limited to $1,000, which is the premium that as been paid. On the other hand, the stock investor would have lost a value of $2,000. So, the upside is not constrained but the downside risk is limited in trading options contracts.

Option contract trading provides a lot of other advantages and also flexibility, all of which we cannot go into in this article. Some popular strategies are selling covered call options, buying puts (to short a stock), trading call-put option spreads, etc.