Purchasing stocks carry with it risk. Your money could be lost if the company goes out of business. You could lose money if the company is losing sales.
What if you could own a ticket that would allow you to purchase a company if it did well? Would it not be kind of like having insurance policy that you could exercise if the conditions were right?
Film or theatrical producers often buy the right – but not the obligation – to dramatize a specific book or script. That is what a stock option is.
A stock option is the right to buy (call option) or sell (put option) a specific number of shares of a company, at a certain price, by a specified date.
They add a delay effect to the normal direct purchasing and selling of companies. This delay if used wisely, can give you added advantages as an investor. Because of this, Options are very sophisticated financial instruments and should only be done once you have a working understanding of the stock market.
Options Help Limits Losses
Consider this for a moment; two men invest in the same stock. One man invests $10,000 and he hopes the stock will rise. A great outcome could be that the stock doubles and the worst outcome is that it goes bankrupt. He could make 100% profits or lose 100%. He either gains $10,000 or loses $10,000 or anything in-between.
The other man invests in the same stock but with proper options. He only risks $1,000 because the options allow him to purchase rights to stocks without having to outright purchase all of them. With these options, if the stock doubles, they will be worth 10 times what he bought it for. His upside is 1,000% gain or $10,000 while his downside is only $1,000 or anything in-between.
Two men invest in the same stock. Both have the same upside potential while one of the men has 10 times the risk. Now this was just to illustrate that high profit does not have to mean unacceptable risk, thanks to Options.
Leveraging with Options
Lets say you have the opportunity to purchase an option on IBM. It would be written something like:
APPL Oct 100 Call at $2.00.
This is a call option. The company associated with it is Apple Computers, trading as APPL on the stock exchange. The strike price is $100. If you own this option, you can decide to buy Apple stock at $100 per share, even if it should be trading at $90 or $110 per share.
The cost to buy this option is $2.00 which is multiplied by the number of shares which is in multiples of 100. This means the lowest amount you could spend would be $200 (100 shares x $2.00) plus your broker commissions.
Each option has an expiry date, in our example, it would be the one month away. If you do nothing and your option expires, you lose your $200 (plus commissions). This may seem like a loss, but it would be better to lose $200 instead of being forced to purchase 100 shares of Apple at $100 or $10,000 only to find that it is now trading at $90 per share. This would result in an automatic unrealized loss of $1,000 and you now have tied up $10,000 of you capital into a stock waiting for it to go up.
Options can also be shorted just like stocks can be shorted. If you believe that a stock will go down in price, but don’t want to pony up the total investment, you can buy an option with a strike price being lower than what it is currently trading at.
It gets complicated, and requires a leap of understanding, but as you can see, if understood and used wisely, stock options can help you immensely in your investment strategy.