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Many people are turning to the stock exchange to make some extra money on their savings, or to even replace their normal income. Options are another tool you can use to trade on the stock exchange, and can be used for normal stocks, futures and indices. If you spend some time learning about how trading options works, it’s possible to make consistent, good returns on your money. For simplicity’s sake, I’ll use trading options on stocks for the examples that follow.

An option is really another way of saying you have the right, or the choice, whether to go ahead with buying or selling a number of stocks on a certain date. When you purchase the right to buy stocks, that’s known as a call option. When it’s a right to sell your securities, it’s called a put option. Initially, most people start out simply, either buying a call option for a stock they’re interested in purchasing anyway, or else buying a put option on stocks they already hold, to protect their investment if the price plunges suddenly. All of the contracts have an agreed price. So in the case of a put option, the stock may be trading at $5.00, and you buy a put option that gives you the right to sell the stock you hold at $4.50 in two months time, if you choose to exercise that option. This means that if the price drops to $4.00, you’ve protected yourself. If the price doesn’t drop, then you let the option expire and keep your shares.

Buying an option requires paying a premium. It’s important to calculate out how much you’re willing to pay for an option, so that it remains cost effective. Options are more expensive the further they are from expiry, and gradually their value falls as the expiry date approaches. The good thing about options is that you can spend a small amount of money (the premium) to control a large holding of stocks. If you spot a stock that you think is about to go up in price, rather than spending $10,000 buying the stock outright, you can purchase a call option for, say, $500. Then, if your analysis is correct and the stock goes from $5.00 to $6.00, you can exercise your call option to buy the stock at $5.50, and make an immediate profit.

If, however, you’re wrong, and the stock price doesn’t move or even falls, you can let the option expire and all you’ve lost is your premium. Again, using the above example of 2000 shares at $5.00 a share. If the stock falls to $4.00 and you’d bought the stock outright, you’d have lost $2,000. With the call option, though, all you’ve lost is the $500 you paid for the option. You go into the trade knowing the maximum amount you can lose - your premium.

Trading options takes some skill, so it’s often a good idea to start out by learning how to trade stocks successfully. Once you’re confident you can spot profitable trades, then you can look at using options to leverage your available funds.

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