Option Trading: Make Sure You Understand The Risks

If you negotiate the right to buy or sell a specific amount of a certain stock at some time in the future at a certain price you are doing option trading. This has the advantage of leverage and is being done by more and more investors all the time.

Option trading can be used as insurance to protect your investments from an unexpected slide in the market. This is what is meant by using a hedge. You buy a put option which gives you the right to sell a stock at a certain price no matter what the current market price of the stock is. If the price of the stock rises then eventually you will let the put option expire and lose what you paid for the put. This reduces the upside potential of the stock while protecting you from losses.

Another conservative option strategy is sell calls while owning the underlying stock. This is called covered call writing; it is a strategy often used by investors to generate additional income on stocks already in their portfolio. This strategy provides limited downside protection in case stock prices fall.

If the stocks drop just moderately, a covered call writer may cushion the blow of the decline since she or he is entitled to a premium for selling calls. But if stock prices drop dramatically, the investors will still lose money as the premium received for calls won’t offset mounting losses in underlying stocks.

If you are willing to take on a high level of risk then you can use leverage to turn small amounts of money into large profits. If you buy an option it gives you right to do something or you can let it expire worthless. Buy call options if you expect rising prices. To speculate on rising prices you either buy calls or sell puts.

If you think the price of the underlying security will go down, then you make money by buying a put now and selling it at a higher price later. To benefit from falling prices you make money by buying puts or selling call options. This is a way to leverage profits but it also leverages losses if you bet the wrong way. If are betting on increasing prices and the option expires before the price goes up, you can’t lose more than the amount you paid plus commissions.

Conversely, speculators who sold the options may lose a great deal more than the premium they got for selling. If you do not comprehend all the terminology of option trading, you may easily gain access to the Options Dictionary as part of your stock option education.

Option trading are generally defined as a contract between two parties in which one party has the right but not the obligation to buy or sell a specified amount of an underlying security at a specified price within a specified time. The great leverage through options attracts more and more speculators. A very conservative option strategy is to sell calls while you own the underlying stock. If you find all the terminology confusing regarding options trading, do a little research with the help of the Options Dictionary as a part of your stock option education.

- David Baxwell