The Basics of Option Spread Trading
The Basics of Option Spread Trading
The Basics of Option Spread TradingOption spread trading can be somewhat complicated for newcomers to the stock market, as it has a high failure to profit rate. Option spread trading isn't for everyone. In particular, it isn't suitable for newcomers to the stock market. You have to be someone who likes to take mitigated risks to enjoy option spread trading. Others would find it torturous. Really, as the veterans of investing will tell you, option spread trading is only for those who have capital they're perfectly willing to lose and a desire to make money.
Option spread trading is a speculative financial venture. If you aren't into speculation, you would be better off with a more traditional investment medium. However, if you like to make money, you should consider learning about stock options. The reason so many people enter into these risky contracts is that it can be very profitable. The best thing to do is learn all you can about the stock market and options before making a decision about it.
There are some advantages to the type of risk involved with option spread trading. For one, it gives you a lot of flexibility over the course of a timeline, to either lose a specified investment or make a profit on it, depending on the value of the stock.
The extra leverage you gain from stock options give you the potential to make extremely high profit margins on relatively small investments. Typically, you will purchase an option for 100 shares of stock. The option will only cost about 10% of the stock value, so you can make a lot of money without having to invest the full price for 100 shares of stock.
Understanding the Option
An option is an intangible item that you own. It is a contract that establishes the right to either buy or sell a stock, or other object. In terms of stock, a specific time frame is set when you can buy or sell the stock, as well as a specific price per share for the transaction. When you buy an option, you are paying for this right and these terms, not for the stock. For this reason, an option is often referred to as a type of derivative, as the value is not derived from the option, but what the option gives you the right to buy or sell.
An Option Spread Trading Real Estate Example
Most people are more familiar with real estate options to buy, and the principle is the same, so let's take a look at an example where you want to buy a piece of property, but you don't have enough money right now. Since you don't want this house to get away from you, you negotiate a price for the house and ask the owner to take a $5,000 payment to give you the exclusive option to purchase the house.
However, the owner doesn't want to hold on to it forever, so he agrees, but puts in the contract that you must pay in full for the house within the next three months or the house will go back on the market. In such a situation, if you come up with the money and don't change your mind, you can buy the house in the next three months at the agreed price. If you change your mind or don't come up with the money, the original owner can do what he wants with the house. Either way, you don't get your $5,000 back, as this was only for the option to buy the house.
This is basically how options work. Your risk is limited to the price of the option, which has the benefit of being a predictable risk. This is the allure of option spread trading.
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