Option trading is becoming increasingly popular. According to Nasdaq, nowadays around 40 million option contracts are traded per day. Since 2010 the average trading volume has grown by more than 160%.

More and more investors are realizing the benefits of options, and brokers are offering very cheap access to option trading. For example, some discount brokers now charge less than $1 per contract.

There are four trading actions you can take with a single option. You can buy a call, sell a call, buy a put, or sell a put. However, you can do multi-legged trades to manage risk as you see fit. Moreover, for a given stock—especially a widely traded one—there so many option contracts with different strike prices and expiration dates to choose from that there is a great amount of versatility in terms of what you can do.

More Exposure With Less Capital

Additionally, options offer leverage. They can multiply the earning potential of your money.

For example, let’s say you have $1,000 to invest. If you are interested in a $50 stock XYZ, the most you can buy is 20 shares. (To keep things simple, I am ignoring any and all trading costs, which nowadays should be negligible. If not, change brokers!) However, with that same $1,000, you would be able to buy up to 10 contracts of a $1 option. You would pay $100 per contract.

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Since each option contract covers 100 shares of the underlying stock, this means you have interest in 1,000 shares of the stock, as opposed to only 20 shares if you purchased the stock outright.

Examples of Leverage at Play

Now let’s say you bought 100 shares of a $52 call on XYZ at $1 expiring in three months. If you hold the call to expiration, and the stock rallied to $54, your gain would be $1,000. The calculation is: ($54 – $52) x 100 x 10 – $1,000. Had you bought the stock instead, your gain would $400: ($54 – $52) x 20. Going the option route increased your profits by 2.5 times.

Of course, the knife cuts both ways. Just like an option trade amplifies your profits when the stock moves in your favor, it can also amplify your losses if the stock goes against you.

In the above example, if XYZ went to $48 instead, the $52 call would expire worthless. You stand to lose the entire $1,000. Had you bought the stock instead, your loss would have been $400.

This assumes that you held the option to expiration. In practice, about 60% of all open option trades are actually closed prior to expiration. About a third expire worthless and only about 7% are exercised. This means that most option traders prefer to close out their in-the-money long option trades rather than exercise the option.

Lock in the Remaining Time Value

If you closed out your position before expiration, your gain or loss would likely be different than the intrinsic value of the option. This is because options have time value and you would be able to get lock in the time value as well.

The intrinsic value is the difference between the strike price of the option and the market price of the stock. If the stock is $54 but the strike price is $52, then the intrinsic value would be $2 per share. Note that if an option is out of the money, its intrinsic value would still be zero. Intrinsic value cannot be negative because the option holder would simply not exercise the option.

Going back to the example of $52 call, if XYZ is trading at $50, it would be foolish for the holder of the $52 call to exercise the option and buy XYZ at $52 when he could just buy the stock on the open market at $50.

On the other hand, time value is the extra something the option buyer is willing to pay for the potential that the underlying stock will move in his/her favor. The farther away the option is from expiration, the higher its time value since the more time is left until expiration. The more time there is left, the higher the chance the stock will move into the money. Thus, it could make sense for someone who’s long an option position to close it out well before expiration.

Editor’s Note: Does uncertainty in the financial markets have you on edge? The key to mastering risk resides in what our colleague Jim Pearce calls “Mayhem Trades.”

Jim Pearce is chief investment strategist of our premium trading service, Mayhem Trader. Jim has developed an under-the-radar strategy to flip market mayhem into fast payouts. Want to learn more? Click here now.

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