We’re happy to see you again. In our last two posts, we discussed the basic components of stock options and how stock options are valued…but why are we even talking about stock options?
The traditional way of trading stocks can be devastating if a company ends up with going bankrupt or the market crashes.
I remember the stock market crash in 2008…but how did my father actually MAKE money during that time period? Trading stock options; had he traded shares instead of option contracts, he may have lost a fortune.
THIS is why I am learning about stock options. I want financial freedom. I want to help others. I am sharing what I learn as I go and love getting feedback from my readers. So why stocks vs. options?
Pick up a copy of Options Trading for Beginners 2020: How to Trade for a Living…here.
Options can Increase Your Odds to Win
The traditional way of trading stocks is through buying shares of stock. Buying shares of a stock can be very risky. One bad scandal, accounting mistake, or what have you, and you can lose everything you have invested.
In this example, we will use a hypothetical investor named Bill. Bill wants to purchase some stock in Pizza X so Bill decides to buy 100 shares of Pizza X for $100 per share. Bill invests $10K for 100 shares of Pizza X.
Then say Pizza X suffers a hard time: a competitor starts crushing Pizza X for sales, and Pizza X can no longer compete goes bankrupt. Bill may have just lost his whole $10k if he didn’t pull out his money.
What about stop orders?
Say Bill has a stop order of $90 on his 100 shares of Pizza X. Pizza X closes the day before at $91 and is projected to drop significantly more the next day. The next day comes and his stop order is filled that morning, but the stock opened at $70. The stop order would be filled at $70, thus, Bill would still carry a $3K loss compared to the $1K loss which was intended.
Now let’s compare that to options.
Put options can be considered a type of “insurance” for stocks and operate 24/7, not only when the market is open. Buying a put option will ensure the right to purchase a stock at a set price, called the strike price for a small premium.
Bill already purchased 100 shares of stock and is worried the stock price will go down. Now Bill decides to buy 1 put contract which always underlies 100 shares at a strike price of $90 at a premium of $0.60. Bill spends $600 to pay for his put contract (0.60 x 100). When the stock drops to $70 the next day, Bill can exercise the put option and later sell his 100 shares for $90 despite the market being lower, limiting his loss to $1,600 compared to $3K.
Another reason that options are less of a risk is because the initial investment is just a fraction of the investment it would take to buy the stocks. In Bill’s case, he would have to invest $10K through the traditional way of buying the stock whereas, he is only required to invest $600 to buy the put options. His potential loss could be $10K with directly buying the stock shares instead of $600 with the put options.
Make More Money
In the above scenarios, Bill invested $10K to buy 100 shares. The market price of the stock goes up from $100 per share to $115, thus increasing the value of Bill’s investment from $10K to $11,500 or a $1,500 gain. Bill receives a 15% return on his investment if he pulls his money out at this time.
Bill anticipates that the market price of the stock will raise to $115 or higher so this time Bill decides to buy call options. He chooses the strike price of $115 and pays a premium of $0.20. One contract underlies 100 shares so his initial investment is $200. The stock price goes up to $120 so Bill closes out his call option.
Bill now has the right to purchase 100 shares of stock for $115 even though the market is currently trading at $120; Bill makes $5 on each share of stock for a total profit of $500 and a net profit of $300. His initial investment is only $200 so his return on investment is 150%.
Now say that Bill has not purchased any stocks and expects that the stock price of Pizza X will go down below $90. He can make money this way too. Bill buys 1 put contract at a premium of $0.60 with a strike price of $95 with an initial investment of $600. The market price drops to $85, and Bill exercises his right to sell 100 shares at $95 making a total profit of $1K or $10 per share. His net profit is $400, and his return on his investment is around 67%.
More Bang for Your Buck
Options are a great way to increase your leverage or buying power in the stock market.
Remember in Bill’s situation how he is required to put forth an investment of $10K into Pizza X if he directly buys the 100 shares of stock compared to the $200 investment required to buy call options which also represents 100 shares of the company. With options, you pay a premium to buy contracts with each contract representing 100 underlying shares compared to paying the full price for the actual purchase 100 shares.
Returning to Bill, his initial investment is $10K in the traditional style of stock trading. What if he uses that money in call options only? Bill can use the $10K to buy 50 contracts of call options at $200 per contract or $.20 per share with the same strike price of $115. If the market price goes up from $100 to $120, that again is a $5 per share gain since Bill’s call option gives him the right to purchase each share from $115.
50 contracts equals 500 underlying shares so Bill makes a gross profit of $25K and a net profit of $15K (25K-10K)! This is still a 150% return on the investment. Bill would have had to have an initial investment of $50K to buy 500 shares of stock if he had not purchased stock options.
More “Options” and Strategies Available
The great thing about stock options are that there are a lot of different strategies that can be used to minimize your risk and maximize your returns. In the above examples, we are buying call options and buying put options only. This is one strategy, but some stock prices don’t fluctuate enough to see the types of gains you might prefer, but the current situation with COVID-19 may be an exception.
There is still some risk associated with buying call or put options. For instance, if Bill buys call options and the stock price goes down or stays the same, he will lose the premium paid. The same goes for buying put options; Bill will lose his premium if the stock price goes up.
Another strategy that can be used is selling call and put options. Another investor buys the call or put option paying you the premium in order to sell them the call or put option. No initial investment is required.
Bill thinks that Pizza X will stay the same or decrease in price, but this time he decides to sell call options instead of buying puts. Bill sells 1 call contract at $0.20 at a strike price of $115. The stock price remains below $115 during the term of the contract, and Bill keeps the $200 profit.
The same goes for selling put options. Bill thinks Pizza X will stay the same or increase in price so he sells 1 contract at $0.60 with a strike price of $95. Bill makes a $600 profit as long as the stock price stays at $95 or above.
An important consideration in selling call and put options is that you can quickly lose a lot of money fairly quickly.
In the first scenario where Bill sells 1 call option contract, let’s say that stock price goes up to $120. That would mean that Bill would have to buy 100 shares of Pizza X at $120 each for $12K and sell 100 shares at $115 each for $11,500. Bill would incur a $500 loss.
Say Bill is wrong in the second scenario where he sells 1 put option at $95, and the stock price goes down to $85. Bill must honor the put agreement and buy 100 shares of stock for $95, a total of $9500. His stocks are currently worth $8500 so he incurs a $1K loss.
Many investors and brokers that trade stock options utilize different types of strategies instead of doing straight buying and selling of options like in the examples above; this is what separates the beginners from the pros. They may have the algorithms and experience, but no one will look out for your money as closely as you will.
As you can see, there are a lot of benefits to trading options over straight shares. Leverage, increased returns, flexibility, and decreased risk are the main reasons for learning more about stock options. Stock options are utilized by people like Warren Buffett and many of the large financial institutions.
Maximize your returns and limit your risk with stock options. There’s no better time like the present to get your finances in order and play a more active role in your financial future.
Stay tuned for more valuable information to help the underdogs like you and me have knowledge and access to information dominated by the top 1%.
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