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Options can seem complicated at first. And if you've wanted to trade options but have held off so far, we're here to help.
Options trading has a unique set of terms you may not have dealt with before. But it doesn't take long to learn the ropes and start trading like a professional.
In this guide to "trading options for dummies," we'll take you through the basics and get you up on your options trading feet in no time.
Not only is learning how to trade options easier than you might think, it's also well worth your time. In fact, you can make money with options trading much more quickly than you can just buying and selling stocks.
Trading Options Can Be Extremely Profitable
When you buy shares of a stock and it gains 10%, the value of your investment increases 10%.
But if you put the same amount of money into options on that stock, that 10% gain could easily translate to 50% gains or more for you.
That's because you're controlling many more shares with an option contract than if you bought the stock outright.
Take VMware Inc. (NYSE: VMW) for example. VMW is trading around $155 per share at the time of writing. But a 10-day call option with a strike price of $155 is trading at just $3.30 per share.
That means you could buy an option contract to control 100 shares of VMW for $330. That's roughly what you'd pay for just two shares outright.
If the share price rises by $20 in the next 10 days, your two shares would give you a $40 gain – minus commissions.
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But if you bought an option contract on 100 shares, you'd now be able to buy $17,500 worth of stock for $15,500.
That's a $2,000 gain, instead of $40 if you had just bought the stock. Again, you spent virtually the same amount of money up front.
Better yet, you don't have to actually go through the process of buying those 100 shares of stock to realize your gains. You can just sell your option contract on the open market to close your position. The price of the option will go up to reflect the move in share price, and you can bank your gains instantly.
Now that you understand the profit potential of trading options, let's look at some of the terminology that will help you navigate your way through the process…
Options Trading: Basic Terminology
A call option gives the buyer the right to buy the underlying stock at a specified price before the option expires.
A put option gives the buyer the right to sell the underlying stock at a specified price before the option expires.
The strike price is the stock price at which the buyer can execute the trade before the option expires.
The premium is the cost of the option itself. Note that this is the price you pay to get the right to buy or sell the stock. Hence, it is a premium on top of the price of the stock itself. Also, since option contracts typically come in 100-share bundles, you have to multiply the premium by 100 to get the actual price of the contract.
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An option is in the money if the underlying share price is favorable to the buyer. So if you have a call option with a strike price of $50 and the stock currently trades at $55, your option is in the money.
An option is at the money if the strike price is the same as the current share price of the underlying stock. And it's out of the money if the strike price is unfavorable to the buyer.