Editor’s Note: Almost 5 years ago, options expert Karim Rahemtulla wrote to his subscribers on the best times for trading options…

“Right now, the market looks VERY promising, jumping around like a banshee. Interest rates are low, home prices have not collapsed, China is still growing and the geo-political situation around the globe stinks. Why is this promising? For options traders, nothing is better than uncertainty and instability.”

And apart from the statement about housing collapse, his commentary rings true today and the market’s trading patterns are looking similar. It’s why we thought it’d be a good time to take a look at some options trading basics…

Many years ago, when I first started trading options in earnest, I remember pausing to think: Why would anyone buy a call option – as in, ever?

I look back now and wonder how I could trade without them.

Many investors hear the words “trading options” and dismiss anything that has to do with them flat out. Concerned about their risk and, in many instances, truly unsure how to use them, options get a mixed reputation from many investors.

They have difficulty looking past the “scapegoat coat” that the options wear.

In reality, using options can be a way to reduce the risk in your portfolio while opening up explosive, life-altering profits. But you need to understand what you’re doing and why…

Trading Options: Call Option Basics

When trading options in the options market, a call option gives you the right to buy a certain stock at a certain price by a certain time. Think of a call option like a real estate transaction…

• Say you know of a piece of land that you’d like to buy because you are fairly certain it is going to become more valuable. Maybe you even know of some development headed that way…
• It’s too good to miss, but you don’t have all the money you need to take advantage of the opportunity – right now, at least. Or you don’t want to tie up that much capital in one investment. It’s a fairly common investing situation.
• So you decide to take an option on the land instead. You approach the owner and offer him a deposit to “hold” the land for you for six months at an agreed upon price.

Let’s add some numbers to this example…

• The price of the land is $100,000. You put up a deposit of $5,000 to have him hold the land for you at $100,000.
• At the end of six months, the land is worth $115,000. Since you still have the right to buy the land for $100,000 and can now sell it for $115,000, you have just made $15,000 on your $5,000 investment.
• When you put up the $5,000, you entered into an option contract with the seller. It gave you the right to buy the land – or not. In options terminology you bought a call.

Your deal satisfied the three criteria that make up an option contract: It had a price, expiration date and premium (the amount you paid for the right to buy the land.)

Trading Options: Harnessing the Power of Leverage

Putting up $5,000 to control a $115,000 investment is an example of smartly using the power of leverage. That kind of leveraging power is what prompted me to buy my first call option. At the time, I didn’t have enough money to buy the underlying stock that had caught my eye.

In this case the stock was IBM, which I had been following for some time…

• It was trading at $82 per share and based on my analysis, I believed strongly that it was ready to move higher. The problem was that I didn’t have $82,000 on hand to buy a thousand shares.
• I decided to buy a call option rather than pass up this trade altogether. But it wasn’t without risks. If the stock moved lower, or didn’t move at all before the contract ran out, I could lose all of my money.
• In this case I had to spend about $2 per option, or about $2,000 total, to control 1,000 shares of IBM. If I was right, I would make a bunch of money. If I was wrong, I would lose my $2,000. Still, that was a better alternative than having $82,000 at risk.
• As fate would have it, IBM did report a blowout quarter, and the stock took off – to the tune of $15 per share.I pulled the trigger when the shares hit $90 and sold my option for an $8,000 net profit, or 300%, days later.

I pulled out early, but you never can lose when you sell at a profit.

Now, if I’d bought the shares instead of using the call options, I would have profited as well. But I would only have made 9.7% and tied up $82,000 instead of $2,000. That’s why investors love trading options, it gives them the ability to use leverage to their advantage.

In addition, most options move much faster than the underlying stock price. It’s how we hit the triple-digit gainers.

Trading Options With Short Expiration Dates? Try LEAPS

One of the biggest complaints I hear about trading options are their short expiration dates. But there’s a simple answer to this problem though, called LEAPS – also known as Long-Term Equity Anticipation Securities.

LEAPS are one-, two- and three-year options that give you control of the underlying shares through the purchase of PUTS (short) and CALLS (long). In short, they give you much longer timelines to invest in the long-term movement of individual securities.

Two to three years is a long time to take advantage of market movements. And more importantly – they reduce your risk. Why risk 100% when you can take 90% of your money off the table and risk only 10%?

Call options and their older brethren LEAPS help you put time on your side when you use options leverage.

Now, options are volatile. Their prices can change rapidly – both up and down. You have to be right about which direction prices are headed and how fast, or you can get nuked in the short term.

Plus, call options can expire worthless if you are wrong about the move of the underlying stock. Despite the big returns options can deliver, they still carry big risk.

I urge you to do your research and find out if using call options and LEAPS are right for your investment strategies and risk levels. Because if they are, you could find yourself looking at a 300% gain at the end of this year instead of only a market return of 14%.

Good investing,

Karim Rahemtulla
Investment Director, Smart Profits Report

Source: Investment U