The 6-Week Options Trading Kickstarter: Leverage, Debits & Credits, and Time & Velocity
Steve Smith breaks down important options trading principles.
Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. Note: Intermediate or advanced-level traders may get more mileage out of Minyanville's 9 Weeks to Better Options Trading series.
Before delving into specific options-trading strategies, I’d like to discuss some general principles. Understanding these principles will help us harness the power of options. These are 1) leverage, 2) debit versus credit positions, and 3) time & momentum.
The principle of leverage is one of the most alluring aspects of options and stems from the notion that buying one options contract allows a trader to “control” 100 shares of the underlying stock. What this means is that a trader can buy an economic interest in a company for a fraction of the cost of the underlying stock.
For example, with Apple (NASDAQ:AAPL) trading around $590, the purchase of 100 shares would cost $59,000. Or even at a standard 50% margin rate, that buy would require a $29,500 commitment.
Now compare that to a January 2013 $550 call, which trades for $65 per contract, or $6,500. That’s just 11% of the capital outlay required for a stock purchase, or 22% for one done on margin. So for a fraction of the cost, we are “controlling” 100 shares, which is the essence of leverage.
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