A Very Simple Example: Trading Stock Options

Let's suppose you want to BUY 1,000 shares of GM at $30.00 per share, but do not have the funds to make the purchase. There are at least two ways of buying GM without immediately spending the required $30,000 (excluding commissions for simplicity sake): (1) You can BUY the shares on margin, or (2) you can utilize 'Call' options (discussed in detail after this example). In either case you would need to have a margin account with your broker.

Trading on 'Margin' (trading the underlying stock itself): If you decided to BUY the underlying GM stock shares on margin, rather than trade/use the options, you would pay $15,000 in cash, and borrow $15,000 from your broker. This choice gives you the ownership of the shares for only half the purchase price of the GM stock in this example. It also gives you all the risks and benefits that go with owning the underlying GM stock. The risk, of course, is that the price of the stock could go down and you could lose the entire $30,000 plus commissions and interest on the broker's loan. On the other hand if didn't know what you were doing and let GM stock drop to below $20.00 a share - your broker would make a margin call, which would mean that you would have to sell some of the shares your bought or send your broker more cash to cover some of your losses.

The benefit of using margin is that the price of GM could soar, and all of the profits at the rate of two dollars per dollar of cash invested less the interest on your loan would go to you. Better yet, your broker would be willing to lend you more money as the price of GM went up. As you can see, there really is no limit on how much you could make when you trade.

Trading 'Options' on the Stock: If you decided to trade/use options, instead of trading the underlying stock, you would have bought 10 Call Options (discussed in detail next) to control the 1,000 shares of stock. These options could cost as little as a few thousand dollars. Call options do not give you ownership of the stock, but they provide the right to buy the desired number of shares (1,000 shares of GM in this example), at a specified price ($30.00 per share in this example), by a certain date which you would specify. An "at-the-money" option, with average volatility, (30%), expiring is six months would normally cost about ten percent of the strike price, ($30.00). In this case, your cash outlay would be only $3,000.

The risk here is that you could lose the entire $3,000 when trading the options, a relatively small amount compared to $30,000 if you were to trade the underlying stock (trading on margin). Another problem is that the price of the stock would have to go above $33.00 per share for you to make money. The benefit is that if the price of the stock does go above $33.00 per share, you start to make a profit. Let's say that the price of the stock was $45.00 per share at expiration. You could sell your Call Options for $15.00 per share, for a total of $15,000. Your gain would be $15,000 and your percent gain on cash invested would be 400%. Not bad. Had you purchased the stock for $30,000 and made $15,000, your gain would have been 50%, which is a great return, but far from a 400% return if you had traded the options as opposed to the underlying stock. Also, let's not forget that you didn't have the $30,000 (in this example) in the first place to put the trade on, so you couldn't even have made the trade.

Some option fanatics can't understand why anyone would ever trade stocks. But please remember trading options isn't that easy either. There are a lot of things you've got to know in order to make consistent money in options (which is exactly what is taught in our Mentoring/Coaching Program. Although there are only two types of options, Calls and Puts (discussed next), they can be bought or sold to open 'Long' or 'Short' option positions, close 'Long' or 'Short' option positions, or exercise 'Long' or 'Short' option positions. Options can be bought or sold above, below or at the option 'Strike Price' (discussed later), with just a short time or up to three years to expiration.

Please remember, there's an infinite variety of trading decisions which can be made when trading options. We will help you to clarify all of this and we will show you exactly what you need to know in order to make money on a consistent monthly basis.