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When To Use Options To Trade Stocks

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When To Use Options To Trade Stocks | An Overview

When To Use Options To Trade StocksUnderstanding 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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