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The Truth about Stock Options and Options On Futures Trading
from: Darren McLaughlinLet's look at the basic facts about options trading before we go
any further. Like any human endeavor, options trading is best
described in very careful language so that there's no confusion
about our meaning. First, let's take a look at exactly what an
"option" is. An option refers to just that, the option to
purchase certain stocks or certain commodity items by a certain
date. This means you do not gain controlling interest in the
stock or commodity until that date. For this reason, options
can, and often do, expire worthless. There are two types of
options contracts:
1) Contracts to buy blocks of stocks by a certain date 2)
Commodity futures which are options to buy blocks of hard goods
by a certain date
If you have options on 10,000 bushels of corn, whoever sold it
to you cannot sell it to someone else until the expiration date
of your contract has expired. In exchange for giving you this
right, they wrote the contract and took money from you. If you
don't exercise your options prior to the expiration date, they
will expect full control of their corn again, and will sell it
someone else. What makes options such fascinating instruments
are these facts:
1) With options you can sell that which you don't own or ever
plan on buying 2) You can buy something you don't ever plan on
physically holding and sell it for a profit
Another great thing about options is their inherent flexibility:
although you have the right to buy or sell a certain stock or
commodity, the choice is yours. You're not forced to exercise
your options. You can always sell your options contract to
someone else. Many traders of commodities and options always
sell the contracts only and have never taken physical possession
of any underlying asset they've ever traded. The leverage in
options gives you a chance to earn extremely high returns. These
types of options we're describing are referred to as covered
options. With covered options you actually plan on or do own the
underlying asset that you purchase options contracts for.
Uncovered options are the exact opposite. Like the word
uncovered means exposed, uncovered or naked options are
considered more dangerous, because you are merely speculating
without having an ownership interest. You are exposed to the
risk without the benefit of owning the asset.
Options trading involves a great deal of leverage in the form of
margin loans to your trading account. All options trades are
highly leveraged, so you need to add margin interest to your
calculated costs when considering a career in trading options.
Pricing and potential returns on options trading depend very
much on real world circumstances. If you purchase corn futures,
for instance, there are literally hundreds of variables that
affect the price of the corn, and hence your investment. If a
corn shortage is expected in a certain part of the world, your
investment might hit big because the price of corn could rise
dramatically. On the contrary, perhaps government subsidies have
introduced a glut of corn into the world market. In that case,
your investment might tumble. Futures contracts for commodities
and options contracts on stocks are strictly based on guessing
what events will happen in the future. Of course you'll always
attempt to make as accurate as a guess as possible, but let's
face facts: in this world unforeseen things can and do happen.
For this reason, protect your downside, and only invest with
money you can afford to lose. Options trading can be very
profitable, but unsurpisingly it's also very risky.
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