Using Options To Leverage Stock Trades | High Risk High Rewards

While stock options can be used for many purposes, from protecting stock positions to reducing the cost of controlling a block of stock, many stock traders prefer using options to leverage stock trades in an effort to maximize stock trading profits.  While using options to leverage stock trades is not terribly complicated, this strategy is quite risky due to the nature of how options derive their value and their potential to expire worthless, causing a total loss of trading capital committed to the options trade.  However, with high risk comes the potential for high rewards, which makes using options to leverage stock trades a tempting trading strategy when traders feel strongly about an imminent stock price move.

Using Options To Leverage Stock Trades | How It Is Done

The strategy of using options to leverage stock trades simply involves buying either call (long) options or put (short) options for a stock at a price level and expiration date that covers the time period in which an anticipated price move in a stock, either up or down, is expected to occur.  What makes using options to leverage stock trades instead of buying or selling short stocks outright risky is that if the options trades do not work out as intended, the options can expire worthless, whereas buying or shorting a stock would maintain a position in the stock that still has value (although reduced due to the unexpected price movement) that could potentially recover.

The advantage to using options to leverage stock trades is that it allows a stock trader to control a much larger amount of shares than they could control for the same amount of money if the stock was purchased or shorted.  With more shares comes more profits, if the stock trade turns out as expected.  Also, stock options often make much larger percentage moves than the underlying stocks that they are written for, and therefore not only do stock options allow a stock trader to control more shares, but they also often make far greater percentage price moves, thus increasing profits tremendously.

The following is an example of using options to leverage stock trades.  To buy 1,000 Facebook’s FB shares at $30 per share would cost $30,000.  However, using call stock options to leverage a long stock trade in Facebook could cost about $50 to control the same 1,000 shares of FB stock for a few months out (which could include a quarterly earnings report or another big Facebook event).  This is because each Facebook option call option controls 100 shares of Facebook, and if hypothetically a trader paid $2 each for ten Facebook call options with a strike price of $30 and an expiration date three or four months out, the 1,000 shares worth of Facebook call options trade would only cost $30 to establish ($20 for the ten call options, plus a $10 commission).  That leaves the stock trader $29,970 dollars to trade elsewhere, while they control 1,000 shares of FB.  Not a lot of money to risk to trade 1,000 shares of Facebook stock.

If Facebook shot higher to $35 before the $30 call options expire, the percentage increase of the $30 call options could be approximately 150% (from $2 per option to $5 per option), rather than the nominal percentage increase of Facebook’s stock, which would be approximately 18% for a price move from $30 to $35 per share.  Given the low cost and tremendous profit potential, it is easy to understand why stock traders like using options to leverage stock trades.

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The Options Spread Strategy | An Overview

The most common of the advanced options trading strategies is the options spread strategy.  The options spread strategy involves simultaneously buying and selling multiple call options contracts on the same stock or commodity in a manner that sets the upper and lower range of the options trade.   The options spread strategy reduces the risk associated with options trading significantly; however, it also reduces the potential rewards associated with options trading since setting up an options spread limits the amount of money that can be earned from an options trade.  If you feel strongly that a stock or commodity will move higher or lower before the options expiration date, then using the options spread strategy might be the wrong options trading approach since earnings are capped when using the options spread strategy.

The options spread strategy can be used in many ways, including:  a bullish options spread, a bearish options spread, a neutral options spread, and a volatile options spread.  The correct options spread strategy to use in a particular circumstance depends upon whether you believe a stock or commodity will move higher, lower, not much at all, or will experience a great amount of volatility.

An Example Regarding How To Use The Options Spread Strategy

While each of the options spread strategies serves a different trading purpose, the following example of a bull call spread options spread strategy provides an example regarding how options spread strategies can be used to reduce options trading risk while potentially still booking a decent options trading profit.

A bull call spread is placed when a trader buys call options at a strike price that is close to the current trading level of a stock or commodity and then sells (goes short) the same amount of call options at a higher strike price to offset the cost of the purchase of initial call option.  Both options must have the same expiration date for the bull call spread strategy to work.

For example, if Apple Computer’s stock AAPL is trading at $450 per share, an options trader looking to put on a bull call spread using AAPL would buy call options close to the $450 price level for $15 per option, and then sell call options at a higher price level (say $475) and pocket $10 per option sold at the higher price level.  This means that the bull call spread in AAPL cost the trader $5 to establish ($15 to buy call options, minus $10 earned by selling call options at a higher price point), but is limited to a $20 profit if AAPL trades above $475 per share before the options expire.  If AAPL trades above $475 per share, the $450 call option will be worth approximately $25, which results in a $20 per option contract profit after the $5 cost of purchasing the option is factored in.  A quadrupling of value of the AAPL call options bought at the $450 strike price, from $5 per option cost to $20 is an outstanding trading profit, but that is the maximum amount of profit that can be earned in this bull call spread example, because the call options sold at $475 put a cap on additional profits, if AAPL’s stock price moves higher than $475.

The nice thing about a bull call spread is that if AAPL were to fall instead of rise, and closed below $450 on the day the option expired, the loss would be limited to the $5 paid to set up the bull call spread.  An options trader in this AAPL bull call spread example would be risking $5 per option to make $20, if the trade works as expected and AAPL rises above $475.  Not a bad risk reward ratio.

The bull call spread options spread strategy is just one of many options spread strategies.  These advanced options trading strategies are somewhat complicated, and should only be used once a trader thoroughly understands how to trade options.  A good way to try out advanced options spread strategies without losing any money is to do a number of paper trades without real money, and become comfortable with implementing options spread strategies.

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Use Put Options To Short Stocks | An Overview

Why do options traders use put options to short stocks instead of just shorting stocks outright?  There are many reasons to use put options to short stocks instead of actually shorting stocks.  The main reason is because establishing a short position in stocks via put options quantifies the risk of going short and the amount of money that can be lost from establishing a short position.  While the intent of establishing any trade is to make money, proper risk management is an important aspect of trading, and going short stocks via put options is an excellent way to manage risk when shorting stocks.  Shorting stocks via put options is especially useful and risk-adverse when the future direction of a stock appears negative and a trader sees it as a good money making opportunity on the short side because they think the stock is heading lower in price, but they want to protect themselves from unexpected upside surprises, such as a company buyout or a big contract award announcement.

An Example Regarding How To Use Put Options To Short Stocks

There are some really good examples regarding when to use put options to short stocks rather than borrowing stocks, selling them short, and holding them as short positions in a brokerage account.  The following is one of them.

Research in Motions (BBRY), which changed their name to Blackberry (their flagship smart-phone product), has defied skeptics and nearly tripled from lows set in 2012, when many thought the company may be heading for bankruptcy and liquidation.  The tripling of a troubled stock is a very tempting short, and many stock market participants are interested in shorting BBRY.  While it may be easier and more convenient to short BBRY outright by shorting the stock, shorting BBRY using short options is a far safer way to short BBRY.

Although, BBRY’s Blackberry is no longer the dominant smart phone, the company still garners interest from many areas in the technology industry and could be a takeover target for either their products, patents, or customer base.  A buyout of BBRY would be devastating to anyone who is short BBRY stock, especially if it turned into a bidding war and the stock kept moving higher.  However, going short BBRY via stock put options limits the upside risk and risk of monetary loss to the cost of buying the BBRY put options, which makes it a far safer way to short such a volatile stock.

Stock traders can also use put options to short stocks to free up trading capital for other purposes.  Since purchasing put options requires much less trading capital than establishing a short position in a stock, the money that is saved by establishing a short position via put options can be used elsewhere, either buying additional put options or balancing a trading portfolio with long positions.

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When To Use Options To Trade Stocks | An Overview

Understanding when to use options to trade stocks can give stock traders a big advantage in the stock market.  While many stock traders think of options as speculative trading vehicles, the truth is that there are times when using options to trade stocks is actually a more conservative approach to trading stocks than buying or shorting stocks outright.  This is because stock options provide certainty regarding how much money can be lost in a stock trade.  You cannot lose more money than the amount of you commit to an options trade, whereas owning a similar amount of stock outright either long or short, can result in significant losses that can be difficult to quantify.  The time to use options to trade stocks is when a stock’s direction is very uncertain and buying options is the safer route to trading a stock than buying or shorting a stock outright.  Using options to trade stocks has the added benefit of allowing a stock trader or investor to control a much greater number of shares, via options, than they could control if they bought or sold short the stock outright, which frees up stock trading capital for other purposes.

An Example Of When To Use Options To Trade Stocks

There is nothing like a real example to understand when to use options to trade stocks.  There are times when a stock trader would like to establish either a long or short position in a stock but is very uncomfortable about holding a stock long or short, due to near term uncertainty.  For example, one might think Apple Computer (AAPL) is a good buy, but with an earnings report not far in the future, they may be hesitant to buy AAPL outright.  Options mitigate these concerns by allowing a stock trader to establish a long position in AAPL at price limit set by the options that they buy, which clearly defines how much money they could lose if Apple Computer announces a bad earnings quarter, and the stock drops in price, but also provides nice upside profit potential if Apple Computer announces a good earnings quarter, and the stock shoots higher.  Instead of worrying about whether they can lose $50, $100, or $150 per share on a bad earnings report, an AAPL trader can quantify and limit the risk of losses to the amount they paid for the AAPL stock options, which is just a small fraction of the stock’s actual trading price.

Another advantage to buying AAPL options to go long AAPL, instead of buying actual shares of AAPL is that since options cost just a small fraction of the price at which the stock is trading (AAPL may be trading at $450 or $500 per share, but options could cost between $5 and $20 each), a stock trader can commit a lot less trading capital to a single trade and focus on other stock trading opportunities.  If a stock trader brought ten AAPL call options at $10 each to control 1,000 shares of AAPL, it would cost the trader $100 plus commission to establish the a long position in AAPL via options.  Each option provides the right to buy (call) or sell (put) 100 shares of the stock that they are written for, which in this example is AAPL.  So, instead of buying 1,000 shares of AAPL for $450,000 or $500,000, a measly $100 plus commissions can be used to control the same number of AAPL shares via options.

Once a stock trader understands the risk mitigation, cost savings, and ability to free up trading capital, it is easy to understand why many stock traders use options to trade stocks.

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An Overview Of How To Use Options To Protect A Long Stock Position

Learning how to use options to protect a long stock position is something that is important for serious stock traders and investors.  Many individual investors incorrectly view options as speculative stock trading instruments that are only used to place bets on the future direction of stocks.  That is one use for options; however, stock traders and investors can also use options conservatively to protect a long stock position in an effective manner to ensure that unexpected negative news does not impact the value of their portfolio and their long stock positions are sold at predetermined levels, should the stock market or an individual stock take a dive.

An Example Of How To Use Options To Protect A Long Stock Position

To use options to protect a long stock position you must first have a long position in a stock.  Although they are relatively inexpensive, options cost money; therefore, options should only be used to protect a long stock position at times when it makes sense to buy such protection.  If you just finished your due diligence regarding a stock and you just purchased the stock, there is no need to immediately start buying protection for your long stock position, if you bought the stock based on sound due diligence and feel strongly it will move higher over time based on fundamentals.  Buying protection too early will just drive up the cost of your stock purchase.  The time to use options to protect a long stock position is after a stock you hold has made a significant run higher and you want to ensure that you capture a profit in the event that the stock has a sharp pull back on unexpected bad news.  Although stop-loss orders can also provide protection from unexpected stock price moves lower, stop losses can sometimes be triggered on quick dips and cause a premature exit from long stock position and stop losses do not protect against situations in which stocks gap down lower in the beginning of a trading session or after a trading halt, while options provide price protection against gaps down.

Here’s how you can use options to protect a long stock position.  Let’s say you purchased Bank of America’s stock BAC during the prior recession at a level below $5 per share.  Since then, BAC has rallied to over $10 per share.  If you are worried that unexpected bad economic news could send BAC’s stock reeling lower, you can use put options to lock in your BAC profit at $10 per share.  Buying put options with a strike price of $10 per share that cover the number of BAC shares that you own will ensure that if BAC takes an unexpected tumble below $10 per share, your profit will be guaranteed at the $10 per share level.  If you think the economic outlook and BAC’s outlook are strong for the foreseeable future, there would be no immediate need to spend the money to protect your long position in BAC by buying $10 BAC put options; however, some traders use put options as insurance policies against unexpected bad news and moves lower in stocks and the stock market.

This article provides a basic explanation regarding how you can use options to protect a long stock position.  Options can be used defensively to protect long stock positions, and are powerful tools that stock traders and investors can put to use to give themselves an advantage in the stock market.

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Options Trading Tips and Advice For Beginners

The best options trading tips and advice is to learn how to use options before even considering buying them.  Buying options is a lot less forgiving than buying stocks, since many options routinely go to zero and lose all of their value very quickly.  For those looking for options trading tips and advice, do your homework, learn about options, and do numerous paper trades (without real money committed) to learn how to use options effectively and avoid common options trading pitfalls.

An Option is a financial contract between two parties to buy or sell a specified quantity of a commodity or stock at a set price on a future date that is set in the contract.  Options trade on options exchanges.  A Call Option is contract to buy a predetermined amount of a commodity or stock.  A Put Option is contract to sell a predetermined amount of a commodity or stock.

Options Trading Tips and Advice | Options Trading Strategies

As if soaking in basic options trading tips and advice isn’t hard enough, what really makes options unique is that their trading strategies can serve exactly opposite purposes.  Options can be used to either take on great commodity or stock trade risk to maximize potential trading gains or to mitigate commodity or stock trading risk to protect trading positions from losses.

Using Options To Maximize Potential Trading Gains – Options often move by a greater percentage than the commodity or stock that they are written against, which makes them useful trading vehicles to maximize trading profits, if a sharp price move is anticipated in a commodity or stock.  However, with the high profitability potential, comes high risk, as options can expire worthless, if the underlying commodity or stock does not move in price as anticipated.  Another way options are used to maximize potential trading gains is that options allow a trader to control a greater amount of a stock or commodity than they could buy if they purchased a commodity or stock outright.  So, instead of making a relatively small bet regarding a future price move in a commodity or stock, options allow traders to make much larger bets than their trading accounts would otherwise permit them to make.

Using Options To Protect Trading Positions From Losses  – Options are relatively inexpensive to buy, especially compared to commodities or stocks that sell for hundreds of dollars per unit or share.  Their relatively cheap cost make holding options a good way to protect a large position one is holding in a commodity or stock against unexpected losses.  For example, if a trader or investor bought Apple Inc.’s stock AAPL for $100 per share years ago, and they are now worried about holding their AAPL position, but do not want to immediately sell it, they can buy put options that are based on the price of AAPL to protect their position in AAPL.  If AAPL falls below the put option price on the day the option expires, then the position in AAPL will be automatically sold at the put price (say $500 per share), even if AAPL is trading much lower than $500 (say $450 per share) on the day the $500 put option expires.

These are just some basic options trading tips and advice.  To truly grasp both the risks and rewards associated with trading options, further research into options trading tips and advice is necessary, as there are many different options trading strategies.

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