Why Options Trading Is A Great Leveraging Tool?

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Dec 26 2006
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The moment we (you and me) know what is money, how to count it and the power of money, we all wish we have more of it – in fact lots of it so that we can buy whatever we wish to have. Ever dreamt of how you can print it yourself when you were kids? I did. But the moment I was made to wash my dad’s car to earn pennies (boy! it was hard work though as a kid I enjoyed it) I knew it’s not easy to earn this piece of note. And when we grew-up we learnt the word “investment” and how we should invest in order to grow our money. And the first thing I learnt was “Stocks” – buy stocks hoping it’ll go up in value and sell it to realize the profit/money.

But we never being taught that to buy stock, there’s only 1 (one) way you can make money – that’s the stock has to go UP. We seldom being taught we can make money shorting the stock as well (human being like being optimistic and bullish somehow gives a good-feel compare to bearish). Furthermore you need to have quite a sum of cash in order to buy stocks. So, stocks were planted into our sub-conscious mind as the first financial instrument to make money. Of course you have other investment means such as properties, unit-trust, currency trading, insurance so on and so forth – but stocks are the preferred one.

For investors with a high level of risk tolerance, options provide great opportunity to use relatively small sums of money to leverage sizable positions. For a fraction of what it would cost to buy large blocks of shares, investors can buy calls (if you think the stock will goes up) giving them the right, but not the obligation, to buy shares at a specific price (strike). But let me warn you, unlike stock, options do not pay cash dividends nor give you the voting rights. The worst thing that can happen is the options may expire worthless – an options buyer risks losing the entire amount plus commission paid.

Options are a great tool for leveraging – for example: a stock which trades at $40 per-share would require $20,000 to buy 500 shares. Using options, you can buy 10 (ten) 40 call contracts at $7. So, for just $7,000 (10 contracts x $7 x 100 shares per contract), you owns the rights to buy 1,000 shares of stock at $40. If the stock price is $60 at expiration, the options will be worth $20 each ($60 – $40) or $20,000 (10 contracts x $20 x 100). You will have a profit of $13,000 on a $7,000 investment.
  1. Stock PriceStock Profit (Loss)Option Profit (Loss)
  • $ 20 —————-> ($10,000) ————> ($7,000)
  • $ 30 —————-> ($ 5,000) ————-> ($7,000)
  • $ 40 —————-> $ 0 ———————> ($7,000)
  • $ 50 —————-> $ 5,000 —————> $3,000
  • $ 60 —————-> $10,000 ————–> $13,000
  • $ 70 —————-> $15,000 ————–> $23,000
In contrast, if you invest in stocks, you will have profit of $10,000 on a $20,000 investment ($60 – $40 x 500 shares). However the risk is high on options trading. If the stock doesn’t move, you will lose the entire investment of $7,000 for the $40 calls if it expires. But if you bought the stock instead of option, you lost nothing because you still own the stock (unless the stock’s company went bust).

That’s the power of LEVERAGING in options trading.

# TIP: Though options trading has the risk of expiry, research and invest in fundamental strong companies together with sufficient time-value are some of the keys to success.

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