When options trading is brought up in investing conversations most dismiss involvement as "too risky" or "highly speculative."
The concept and risk of options leverage usually scares people away.
These connotations are only reinforced by the fact that online and brick and mortar brokers are required to obtain the investor's signature on a"Risks of Options Trading" or "Option Agreement" form.
Yes, it is true that any derivative investment will generally carry more risk than simply buying into the underlying stock. Any investment in stock market equities or derivatives thereof is of course inherently risky when compared to treasury bills, for example.
Heck, driving a car is risky if you don't know what you're doing. So does that mean we should all stop driving or riding around in cars? No, you mitigate your risk by doing things like wearing seat belts.
The wonderful thing about stock options is the purchase of equity option contracts allows the investor to control large blocks of a particular stock without tying up the large sums of money that would be required to own the stock itself.
To understand this concept fully, it is important to have a thorough grasp of options leverage.
When people refer to the leverage of options trading, what they are simply saying is that you're going to use a small sum of money to make a large sum of money.
Here's an option trading example from our options course as well as a dialogue I had with one of my readers:
Let's say you do some research into the healthcare industry. You find a good company and based on your research you feel the stock price will increase over the next few months.
You look up the stock price and "HUM" is currently trading for $42 a share. You buy 10 option contracts that give you the right to buy 1,000 shares of "HUM" at a set price of $45 anytime between now and March.
The contracts cost you $1,665. That is what they were worth the day you bought them when the stock was trading at $42 a share. This $1,665 is a small price to pay compared to the $42,000 you would have paid if you bought the stock outright ($42 * 1,000 shares).
Eight days pass by and the stock price of Humana, Inc. increases in value as you expected. The stock is now trading for $46 a share ($4 more). Now that "HUM" is trading for $46 do you think your contracts are worth more than $1,665? Yes they would be!
Think of it this way. "HUM" has increased in value by $4 since you bought your contracts. When "HUM" was trading for $42 these contracts were worth $1,665.
Since the contracts are now worth more money you essentially turn around and sell them to someone else for lets say $2,534. In doing so, you would make a quick $869 or 52% return on your money. Not bad for 8 days of work.
Reader: in the example above, why not exercise the option, buy the stock at 45 and sell it at 46 resulting in a profit of $1,000 (less fees, etc) that is greater than the $869 shown in the example?
Me: It actually may not be a greater profit. It would depend on how much you pay in commissions to your broker.
Another thing to look at is why would I tie up $45,000 worth of my money just to make $1,000 when I can spend $1,600 to make roughly the same amount of money.
The stock trade ties up $45,000 just to make a $1,000 while the option trade only ties up $1,600 thus leaving $43,00 still in their account to find more option trades with.
Reader: And maybe that's where I am getting a disconnect.
It appears that the funds (45k) would only be tied up for a short period, between the time the option was exercised and the stock was sold, seeming just a few minutes.
This would also seem to eliminate any variables (unknowns?) with the stock valuation calculations.
Am I missing something?
Me: No you're not missing anything. You can make the profit both ways. The only thing you may be missing is that most people don't have $45,000 to invest with, but most can scrape together $1,600.
So people use options trading to make the same profit with a little bit of money thus realizing the same profit potential as a stock trader, but with a whole lot less money tied up.
So that is a perfect example of the leverage of options trading. Instead of buying the stock you take just a little bit of money, buy an option, and walk away with roughly the same profit.
Options leverage allows you to start trading with a small amount of money and at least have a fighting chance at succeeding. However, it doesn't mean you should try to trade with a small account, but at least the option is available.
To learn more about these concepts and to see real life example of the profit potential of options, be sure to check out our private email list.