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What is the difference between share, future, and option? What we know is that option is much cheaper than the share and future, usually is tenfold lesser than the share price. So, if you have an amount of money that enough for you to buy 100 units share, you can use that amount of money to buy the 1000 units option. And the return of investment is almost the same between share and option. Therefore, you will earn around tenfold if you buy an option rather than a share or future. However, the disadvantage is that if you lose on that trade, you will lose almost tenfold also. When we trade option, the amount of money that we can profit and lose is almost the same as if we trade share. However, we need a lot of money to buy shares compared to the buy option. This causes the percentage of the profit and loss for buying option is much higher than share. The example is like when you buy $10 for one unit of share and $1 for one unit of option. When the share price drops to $0.10, the percent drop for buying a share is 1% but for the buying option, the percent loss is 10%. That's why the percentage of the profit and loss for buying options is huge compared to buying shares even though the share price fluctuates in a small amount.
Due to the high profit and loss when buying option, trading, or investing option is just like gambling. It is quite normal that the return of investment is more than 100%. But it is also quite normal that you could lose all your money in the investment or trading. In order that you can earn more than lose, you need to know some basic options trading strategies and technical analysis. The option is different from the share. The option has a time value; whereas, the share does not have a time value. The value of one share will not depreciate due to the passage of time. It is only affected by supply and demand and also company performance. However, the option value will depreciate when the time has passed. When the time reaches the option expiration date, there is no more time value for that option. That is why, you need to use a strategy to trade options, in order that you can minimize the loss and maximize the profit.
The very basic two option trading strategies are bullish call spread and bearish put spread. A bullish call spread is used when the stock price is anticipated to rise in the coming months; while, a bearish put spread is used when the stock price is anticipated to drop in the coming months. Steps that are involved in this strategy are buying in the money option and selling out of the money option. In the money option is the option that has time value and intrinsic value; whereas, out of the money option only has a time value. When the stock price moves to the positive side (generated money side), the money option will generate profit, and the out of the money option will cause loss. However, the minus of the profit and the loss is the net profit that has generated from this strategy. When the stock price moves over the out of the money strike price, the profit will become maximized. Continuously moving the stock price to the positive side will not generate any profit. In this situation, we will close both positions to take the profit out from the market.
If the stock price moves to the negative side (the opposite side that cause loss), in the money options value will depreciate and the out of the money option will generate profit. However, the profit, which is generated from the out of the money, is limited to the price that you have sold. The subtraction between out of the profit of the money and in the loss of the money is a negative value. This is because the profit that is generated from the out of the money option is less than the loss that is caused by the money option. Out of the money options profit is limited in this strategy and in the money options loss is unlimited. If the stock price continuously moves to the negative side, you may lose all of your capital. So, what is the difference between buying naked options and buying option using the spread strategy? The difference is that you may lose more money if you buy the naked option and lose less money if you buy spread. This is because you do not generate any profit when you just buy the naked option; whereas, profit is generated from the out of the money option if the stock price moves to the negative side. The disadvantage of the spread is that the commission, which is charged by the broker firm, is double compared to the naked option. This is because the naked option only involves one position; whereas, the spread involves two positions. Each position will be charged with commission separately.
Besides, the purpose of selling out the money option in the spread strategy is to minimize the loss of the time value of the in the money option. Actually, both in and out the money options time value would depreciate when the time has passed. Because we do not own the out of the money option; therefore, we can keep the money that we have received from selling that option. When the time value of this out of the money option has depreciated, we used a lower price to buy back the option. So, we sell at a high price and buy back at low prices; therefore, we earn money. The money that we have earned usually is enough to cover the loss of the time value from the in the money option. However, you still lose the intrinsic value of the option if the stock price moves in a negative direction.
So, bullish call and bearish put spreads are two of the very basic option trading strategies. However, it is not guaranteed 100 % win from the stock market. You still need to learn to predict the stock price direction accurately using technical, fundamental, and news analysis.
