Even if you just started to research options as a potential addition to your portfolio, you’ve probably seen some the advertisements that talk about how options allow investors to “control” hundreds or even thousands of shares of a company’s stock for just a fraction of the price of buying the shares directly. That bit of information may have you scratching your head and wondering how is it possible to play with the big boys for just a small slice of the normal cost. Well, that’s a reasonable question and the answer is why so many investors have found their way to options in recent years. Let’s take a look at why options investing is the place for giant returns.
Leverage, Leverage, Leverage
Leverage has become a four-letter word of sorts as its abuse had a hand in the collapse of a few major financial institutions, but leverage is not a bad thing when investors understand it and know how to limit their risk. Here’s how leverage works with options. Let’s say you want to buy the August 25 calls in Microsoft. Remember that each equity options contract grants you control of 100 shares of stock. Microsoft is trading at $23 a share and the calls are trading for $1. That means that when you purchase one contract of the August 25 calls, your costs AND your risk is $100. (The price of the contract is $1 x 100 shares). If you had bought 100 shares of Microsoft in the market, your cost and risk would’ve been $2,300.
Now you’re starting to see one of the biggest attractions of options investing. If your Microsoft shares go up $1, you make $100. Great, but you’ve also exposed $2,300. If your calls leap to $2, your investment has doubled with very little risk. This is how leverage works in the options investor’s favor. Lots of profit potential, at a more rapid pace than with stocks, all with a very low risk profile. The worst thing that can happen when buying puts or calls is that the contract expires worthless and you lose the premium paid to enter the trade. You’d lose a lot more if a stock you owned directly fell to zero.
More Options Advantages
As you can see, options are far more cost-efficient than stocks. If you have $20,000 to invest and you are interested in a $50 dollar stock, buying just 400 shares would eat up all of your funds. On the other hand, you could buy three $10 calls for $3,000 ($10 X 100 shares = $1,000) and still have plenty of funds left over to diversify your investments with.
Options are also superior to stocks in that once you graduate to more advanced options strategies you’ll see the versatility of this asset class cannot be beat. When we trade stocks, we really only have two choices: Go long, which means we buy a stock in the hope that it will go up, or sell short, which means we want the stock to decline.
Sure, we can go do that with options, too, but we can also profit with options during range-bound markets. We can also use options to generate income by selling covered calls on stocks we already own. More advanced options traders use strategies like spreads, collars, straddles and others to profit from a variety of market conditions. It’s even possible to add a new options position to an existing one to bolster your chances of profitability. Try doing that with stocks!
Don’t Forget Higher Potential Returns
Obviously, investors love options because the chance exists to make more money faster than with many other asset classes. Hence the beauty of leverage. Evaluating an options contract’s profit potential means we have to look at its delta. Delta is the measure of how much the contract will move in relation to the underlying stock. Let’s say that we’re looking at buying some Pepsi calls that have a delta of 0.8. This means that for every dollar Pepsi stock goes up or down, our calls will increase or decrease by 80 cents. That’s a high delta contract. We buy those calls at $5 a contract ($5 x 100 = $500) when Pepsi is trading at $50 in the open market. Then the stock shoots to $55, so while the stock investors made 10%, our options with a delta of 0.8 went up $4 in value, or 80%. We made $400 on a $500 investment. That’s a tough return to beat.
Versatility, Profits and More
We’re not saying that you should completely pass on other investment vehicles because options are so wonderful. Yes, they’re great tools, but at the end of the day, you want your portfolio to be diversified. That said, the versatility options offer combined with profit potential that is impossible to ignore make this asset class worth learning about. Take the first step into the world of options. Your portfolio will thank you.
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