That's a net dollar return of $9,990, or 200% on the capital invested, a much larger return compared to trading the underlying asset directly. (For related reading, see "Should an Investor Hold or Exercise an Option?")

**Risk/Reward:** The trader's potential loss from a long call is limited to the premium paid. Potential profit is unlimited, as the option payoff will increase along with the underlying asset price until expiration, and there is theoretically no limit to how high it can go.

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MORE IDEAS FROM Options Trading Strategies: A Guide for Beginners

Options are conditional derivative contracts that allow buyers of the contracts (option holders) to buy or sell a security at a chosen price. Option buyers are charged an amount called a "premium" by the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless, thus ensuring the losses are not higher than the premium. In contrast, option sellers (option writers) assume greater risk than the option buyers, which is why they demand this premium.

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Options are divided into "call" and "put" options. With a call option, the buyer of the contract purchases the right to *buy *the underlying asset in the future at a predetermined price, called exercise price or strike price. With a put option, the buyer acquires the right to *sell* the underlying asset in the future at the predetermined price.

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A put option works the exact opposite way a call option does, with the put option gaining value as the price of the underlying decreases. While short-selling also allows a trader to profit from falling prices, the risk with a short position is unlimited, as there is theoretically no limit on how high a price can rise. If the underlying rises past the option's strike price, the option will simply expire worthlessly.

**Risk/Reward:** Potential loss is limited to the premium paid for the options. The maximum profit from the position is capped since the underlying price cannot drop below zero.

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Now, let's say a call option on the stock with a strike price of $165 that expires about a month from now costs $5.50 per share or $550 per contract. Given the trader's available investment budget, they can buy nine options for a cost of $4,950. Because the option contract controls 100 shares, the trader is effectively making a deal on 900 shares. If the stock price increases 10% to $181.50 at expiration, the option will expire in the money and be worth $16.50 per share ($181.50-$165 strike), or $14,850 on 900 shares.

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Suppose a trader wants to invest $5,000 in Apple (AAPL), trading around $165 per share. With this amount, they can purchase 30 shares for $4,950. Suppose then that the price of the stock increases by 10% to $181.50 over the next month. Ignoring any brokerage, commission or transaction fees, the trader’s portfolio will rise to $5,445, leaving the trader with a net dollar return of $495, or 10% on the capital invested.

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There are some advantages to trading options. The Chicago Board of Options Exchange (CBOE)** **is the largest such exchange in the world, offering options on a wide variety of single stocks, ETFs and indexes.1

Traders can construct option strategies ranging from buying or selling a single option to very complex ones that involve multiple simultaneous option positions.

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Suppose a trader buys 1,000 shares of BP (BP) at $44 per share and simultaneously writes 10 call options (one contract for every 100 shares) with a strike price of $46 expiring in one month, at a cost of $0.25 per share, or $25 per contract and $250 total for the 10 contracts. The $0.25 premium reduces the cost basis on the shares to $43.75, so any drop in the underlying down to this point will be offset by the premium received from the option position, thus offering limited downside protection.

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A covered call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares. When the trader sells the call, the option's premium is collected, thus lowering the cost basis on the shares and providing some downside protection. In return, by selling the option, the trader is agreeing to sell shares of the underlying at the option's strike price, thereby capping the trader's upside potential.

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RELATED IDEA

*HEIKIN* - Average, *ASHI* - Pace

Heikin Ashi pattern represents the average pace of the prices. These patterns are useful for getting an idea of the price trend.

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Learning how to be a better investor/ trader

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When it comes to wealth creation in equity market, investing and trading are the two genres of the field. However, investing and trading are very different approaches of wealth creation or generating profits in the financial market. Imagine, today, you and your friend bought equal amount of seeds to sow in your fields but you sold them to someone in a day because you could earn profit. And your friend sowed the seeds and let them grow for a few years till they gave new seeds. He sowed the new seeds and continued this for years and sold a lot more seeds eventually than were bought.

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We always think about the risks involved in making a big chance in life. We consider the risks and then decide not to do it. But, the risks shouldn't scare us into inaction.

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