Investing in the stock market is one of the best ways to build long-term wealth. While most people consider investing in stocks, bonds, and mutual funds, trading options is often overlooked. While there is risk and complexity that comes with buying and selling options, there is also a significant amount of profit potential.
Prior to starting to invest in options, a trader must first understand what an option is. An option is a contract that provides you with the ability to buy or sell a certain amount of shares of stock at a set price at some point in the future. To buy and sell options, you will first need to open a brokerage account that allows it. Most brokerage accounts will allow a novice investor to trade options, but it will often come with limited margin capabilities.
Once you have been approved for an account, you will need to visit the Options Chain of your brokerage firm. Once you have entered the options chain, you will be able to search for a wide variety of available contracts. If you believe that stock XYZ is poised for growth in the near future, you should search for that stock in the options chain. Your brokerage firm will then show you all of the option contracts available.
If you believe that stock XYZ will increase in value, you should purchase a call option on the contract. The options chain will tell you when the option contract will expire, what the strike price will be, and what the call price will be. The call price is essentially the fee that you will pay to buy the contract. This means that the stock will need to increase in value to a point that is in excess of the strike price plus the call price.
For example, if stock XYZ is currently trading for $25 per share and you believe it will increase, you may want to buy a contract to buy it at $27 per share, but will also incur the $1 fee. If the stock increases in value to $30 per share, you will make a profit of $2 per share. If it increases to $40 per share, you will make a profit of $12 per share. This essentially provides you with an unlimited profit potential. On the opposite side, if the stock deceases in value, all you will lose out on is the initial call fee.
While it is important to focus on the strike and call price, you also need to focus on the expiration time. Option expirations can range from a few days to several years. In general, the longer the expiration, the more the fee will be. If the stock does not increase in value to bring you to profitability before the expiration, you will lose the entire initial fee.