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Tomorrow, you could begin doubling your account every single month starting with one letter.
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If your interested in equities, options allows you to participate in the upside potential of a stock with far less capital than by buying the stock outright. For example, if you are bullish on IBM when it's trading at $100 a share, you could buy 100 shares for $10,000, or get super-aggressive and buy that same 100 shares with $5,000 of your own money and $5,000 on margin (which would require you to pay interest to the brokerage firm).
Alternatively, you could buy one options contract for a premium of $5 a share, or a total cost of $500. (Remember one options contract equals 100 shares of stock.) Let's say your option has a two-month timeframe and a strike price of $105. That means if the stock were to rise above $110 a share, the $105 strike price plus the $5 a share premium you paid, you can exercise your option and own the stock at $110 a share. In fact, the buyer can, at his or her discretion, call those 100 shares of stock any time from the moment they buy the call option, until expiration. Compare that to the capital requirement of $5,000 on margin or $10,000 for an outright purchase of the stock. I'd say the option investor got both a better deal and tied up a lot fewer greenbacks to accomplish the same thing.
Managing Your Risk
There's no such thing as a risk-free trade, unless maybe you're buying short-term Treasuries backed by the U.S. Government. By using options, however, you are able to define the exact amount of risk that you're willing to take when you enter the trade. The stock buyer or seller has virtually unlimited risk that can escalate in the event of a margin call, or a short squeeze. If you buy 10 call options with a premium of $5, your total risk, if that option expires worthless, is $5,000. If the underlying stock drops from $100 to $5 a share, you still can't lose any more on those call options than the premium that you paid – in this case, $5 times 1,000 shares (10 options contracts, each representing 100 shares).
With the outright purchase of a stock, however, you could, conceivably lose all of your investment. If you bought 1,000 shares of a $100 stock that, theoretically, means you've got $100,000 at risk. If the shares decline sharply in value or (as happens only rarely) lose all of their value because of some underlying problem, a stock could potentially go to zero. Those problems might be alleged corporate fraud, such as in the case of Centennial Technologies Inc., which has faced lawsuits rising from allegations of inflated sales and net income (Dow Jones, April 30, 1998, "Centennial Tech/Final Court"). Or legal exposure, such as in the case of Dow Corning and the breast implant litigation (Dow Jones Business News, April 13, 2000, "Appeal Hearing Over Dow Corning Breast Implant Settlement Plan Ends").
The tradeoff however, is time. If you buy a stock, you own it; you can hold it for a day or the rest of your life. An option only has value for a defined period of time. If you buy March calls in January, these options will have value for two months. After the third Friday of the expiration month (March in this example), the options is no longer exercisable or assignable.
Sophisticated Trades
When you buy a stock, you're long that security. To make money, the share price has to increase. Or, you could sell a stock to take a profit or short a stock because you think it's going down. Basically, there are two ways to play stocks – you buy them or you sell them.
But, there are myriad of ways to play options. Even retail investors can undertake at least a half-dozen options strategies, combining buying and selling put and call options.
Taking Advantage of a Trading Range
If you buy a stock and it stays in a trading range, your investment is on hold. You do not make money unless the stock price moves in your direction. But, options also allow you to make money if you believe a stock or an index will stay in a trading range.
There are many reasons stocks stagnate in a trading range, such as: a recent acquisition, the cyclicality of its business, or a recent earnings announcement that leads Wall Street to believe there are no surprises ahead in the short term. Not surprisingly, playing a trading range for an index is even more popular than playing a range for an individual equity. This is because the very nature of an index is that its diversification of stocks smoothes the performance and volatility of its individual components.
PLEASE READ: Auto-trading, or any broker or advisor-directed type of trading, is not supported or endorsed by TradeWins. For additional information on auto-trading, you may visit the SEC’s website: All About Auto-Trading, TradeWins does not recommend or refer subscribers to broker-dealers. You should perform your own due diligence with respect to satisfactory broker-dealers and whether to open a brokerage account. You should always consult with your own professional advisers regarding equities and options on equities trading.
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