Online Option Trading

Written by Jacey Harmon
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There are two ways investors in the stock market can increase their leverage: margin and options. Margin is the borrowing of money from a stock broker to purchase shares of a company. The maximum amount a person can borrow from a broker to purchase stock is 50 percent. For example a person with $5,000 can purchase up to $10,000 of stock. Margin increases the potential reward on an investment but it equally increases the potential risk.

Understanding Equity Options Contracts

Options are contracts that state a person will deliver a security at a specified price on a specified date. There are two types of option contracts for investors to utilize: "calls" and "puts." A call option is bought when an investor believes the underlying security will rise. A put is bought when an investor believes the underlying security will fall. Each equity option contract controls 100 shares of the underlying security.

There are three main components to an option contract: underlying security, strike price, and expiration date. The underlying security is the stock that will be delivered on the specified deliver date. The strike price is the price the holder of a contract can buy or sell the stock. The expiration date is the date the contract expires and this plays an integral role in valuing an option contract. For example, an ABC October 50 call indicates the holder can buy 100 shares of ABC on the third Saturday of October for $50 no matter where the stock is trading.

Option contracts are quoted on a per share basis. For example, an option quoted at 3.5 would cost $350 to buy. Options that are priced below $3 are traded in $5 increments, options trading above $3 are traded in $10 increments. Options are traded on the Chicago Board of Options Exchange, and traders need to qualify their accounts before engaging in options trade.

Using Options as Leverage

Since one option contract controls 100 shares, you can control a large amount of shares for a smaller investment. For example, a stock trading at $50 would cost $5,000 for 100 shares without any commissions. If a $50 call contract was trading at five, you can buy 10 option contracts and control 1,000 shares.

The leverage comes with a price, as option contracts are very risky. Each option contract has a "time premium" built into the stock price. If an ABC December call with a strike price of $50 was trading at 4, and the underlying security was at $48, the call would have a $4 per share premium. As the expiration date approaches and the stock remains below the strike price, the time premium will be reduced. If the strike price isn't met at the time of expiration the contract will expire worthless.

Most online stock brokers are licensed to sell stock option contracts. Commission costs for option trades will generally be higher than those for stock trades. This is due to the lower liquidity of options than individual stocks. Commissions from online discount broker will range from $13 to $50 per trade.

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