Options Trading: A Great Way To Make Money Quickly (Or Lose It Even Quicker)
When it comes to investing in stocks, there are two major categories of investors. These are the ordinary investors, and sophisticated investors. Actually, there’s a third category – the gamblers – but that’s a story for another day.
Ordinary investors do what seems like the commonsense thing i.e. buy stock, wait for their prices to rise and sell them for a profit. This approach works – as long as the prices of stocks keep rising. The problem arises when stock prices fall. The result is losses, panic, and confusion.
If you have been following the stock market, then you are familiar with the cycles of euphoria and panic which characterize it. You know precisely what happens when stock prices take a dip: a wave of panic sweeps through the stock market; people rush to offload stocks – which drives prices even lower. In most cases, trading has to be suspended in order to contain the panic.
This panic arises because most investors in the stock market are ordinary investors. They don’t have a strategy to mitigate their losses when their stock prices fall below the purchase price. Sophisticated investors are smarter than this. They use lots of tools to mitigate their losses. One of the tools they use is called options trading.
What Are Options?
An option is basically a contract which can be bought on a specific asset. Once bought, this contract gives the buyer a right – but not an obligation – to buy or sell the underlying asset at a specific price on or before a specific date.
Okay, this sounds a little gobbledygook. So let’s use an example.
Imagine you are an ardent fan of 1960s James Bond movies. So, you want to buy one of the cars driven by 007 in the movies. You Google up the car driven in Goldfinger, and discover it is an Aston Martin DB5.
You go searching for someone who has the car, and find someone willing to sell it for $400,000. Unfortunately, you don’t have the $400,000 in your account. However, you are confident that you can get it in 3 months’ time.
So, you buy an option worth $10,000 for three months on the car. This basically means that you reserve the right to buy car within three months. The owner cannot sell it to someone else.
Now, let’s imagine that having secured an option on the car, you find an expert to authenticate it. For the sake of learning, let’s imagine the expert comes up with two different verdicts.
1. The expert discovers that that car is one of the 4 cars originally built in 1964 for the movie Goldfinger. This discovery brings causes Sean Connery to offer $3 million for the car. In this scenario, the owner is obligated to sell to you the car at $400,000. You can sell it on to Sean Connery, and make a profit of $2.59 million.
2. The expert discovers that the car is actually a fake. It is a clever handiwork of Chinese forgers – and isn’t an Aston Martin DB5 at all. In this scenario, you choose not to buy the car. Still, the $10,000 you paid for the option goes down the drain.
The same applies to when the deadline passes without you getting the $400,000. In this case, the owner is free to sell it to another person. Your $10,000 goes down the drain.
In a nutshell, that is how options work. The only thing is – rather than using options with cars – people typically use options in stocks. However, the basic principle is the same.
-You buy an option on a stock
-That option gives you the right to buy or sell the stock at a given price on or before a specific date.
-You can choose to exercise this right or not exercise it. The option gives you a right – but not an obligation – to buy or sell.
Given their nature, stock options make it possible to scoop a profit irrespective of the direction the stock prices take. With options, you can earn a profit whether the price goes up or down. This is why sophisticated investors use options.
Calls and Puts
We earlier mentioned that options trading can enable an investor to earn a profit whether the stock price rises or falls. The secret to this is simple: there are two types of options. In stock market speak, these are called calls and puts.
Before defining these types of options, let’s first meet the parties involved. As mentioned earlier, an option is simply a contract which can be purchased on an asset. This means that there are two major parties involved in options trading i.e. a buyer and seller.
In stock market jargon, the buyer of the option is referred to as the “holder”. The seller is referred to as the “writer”. For this article, we shall stick to the more mundane terms of buyer and seller. However, if during the course of further reading, you come across the terms “holder” and “writer”, know that they are referring to the buyer and seller respectively.
Another important thing to note is the concept of expiry date. Each option has a specific date on which it expires. The holder reserves the right to buy or sell the stock from the moment of purchase until the expiry date. If the expiry date passes before they exercise this right, then they lose the right over the stock.
Now, let’s discuss the two types of options:
A call gives the holder (or buyer, if you like) the right to buy a stock at a certain price within a specific time period. A call is typically bought with the expectation (or hope) that the price will rise significantly before the expiry date.
Let’s use an example. Assuming the current price of Facebook stock is $125 per share. Now, say you have a tip (or hunch) that the price of Facebook stock will soar to $500 within the next 72 hours. Perhaps you’ve heard that Facebook is about to announce a hostile takeover of Google.
You place a stock option call on Facebook shares which is set to expire within 72 hours. If the price of Facebook’s shares indeed soars to $500. You can still buy the stock at $125 per share, and quickly sell it at $500. This basically means that you earn a significant profit.
This is what a call does. It enables you to earn profits on the rises of stock prices. Basically, once you purchase a call on a given stock, even if the price rises a thousandfold, the seller is obligated to sell it to you at the price agreed when you purchased the option.
A put is the exact opposite of a call. A put gives the buyer the right to sell a stock at a given price within a specific time period. A put is typically bought with the expectation that the stock price will drop before the expiry date.
Let’s use the same example of Facebook with a current stock price of $125 per share. Let’s imagine that you’ve got a tip that Facebook has hit record losses, and is about to announce the sales of its subsidiaries Instagram, WhatsApp and even its mobile Facebook Messenger. You know this could drive down its share price to about $50 per share.
You place a stock option put on 1,000 Facebook shares scheduled to expire within 3 days. If Facebook indeed announces record losses and its share price tumbles to $50, you can still sell your shares at $125. This basically means that you can purchase the 1,000 shares at $50 and sell them at $125. The end result is that you earn profits from the drop in share prices. This is exactly what puts do – they enable investors to make money even when stock prices drop.
Leverage – The True Power of Stock Options
The main reason why sophisticated investors love options is something called leverage. Now, leverage is basically using other people’s money to earn profits. Well, the technical definition of leverage is “the use of financial instruments or borrowed capital, such as margin, to increase the potential return of an investment”.
Okay, that’s a mouthful. In simple terms, leverage using other people’s money to make a buck. That is essentially what it means. And that is why sophisticated investors love options trading. So, how do options offer leverage? The answer to this is simple: because stock options are usually priced far below the actual stock price.
To explore how leverage works, let’s go back to the example of Facebook shares. To simplify the arithmetic, let’s assume the current price is $100 per share.
Let’s say you have $51,000 you would like to invest in stocks. However, because you are a rookie, you want to start with $1,000. If you are to buy Facebook shares at $100 a pop, you will end up with 10 shares. If, two days later, the price rises to $105, you can sell your shares and make a profit of $50. Not bad for a rookie.
Now, what if you use options? Well, stock options are usually sold in lots. For a share priced at $100, a lot of 100 shares can be priced at $200. This is an option of $2 per share. This basically means that, for $1,000 you can purchase 5 lots of Facebook shares, and end up controlling 500 shares.
Given that the stock are priced at $100 per share, having 500 shares means that you have control over stock worth $50,000. This is what is called leverage. For a $1,000 down payment, you have control over a $50,000 investment.
If two days later, the stock price rises to $105 per share, what do you do? Well, you take your $50,000, purchase the 500 shares at $100 per share and quickly sell them at $105 per share. You make a profit of $2,500. Subtract the $1,000 you purchased the stock options with and you have a clean $1,500.
Compare this to ordinary trading, and you see why options trading rocks. In ordinary trading, the $1,000 invested returned a profit of $50. With stock options, $1,000 invested returned a profit of $1,500. This is a 150% ROI in comparison to a 5% ROI. See the difference?
The secret to the massive ROI is that options trading offers leverage. This is exactly why sophisticated investors love options. It enables them to control large stock investments with little down payments and reap the benefits when the market moves in the right direction.
Are There Any Risks?
Anything which carries the potential for great reward typically involves a significant amount of risk. This is true for all investments. Stock options aren’t an exception.
Options are typically categorized as “speculative” investments. And this rings true. They carry a significant amount or risk. In fact, they carry much more risk compared to ordinary stock trading. There are two reasons for this: the money used for purchasing the stock options, and the expiry date.
For starters, the money used for purchasing the stock options is non-refundable. Once you’ve purchased the option, it is yours, period. You cannot ask for your money back. Basically, if the market moves in the wrong direction, and you decide not to exercise your rights to buy or sell, you lose.
Using the above example, let’s imagine you’ve bought options on 500 Facebook shares at $1,000. If the price of the shares falls to $90, instead of rising, you may choose not to buy the shares. When the deadline passes, you basically lose your $1,000. There is no getting it back.
A person who bought 10 shares for $1,000 is in a much stronger position. If the stock price drops to $90 per share, they have two alternatives. They can hold on to the stock and wait for its price to rise. Since there is no expiry period, they can hold on to the stock indefinitely. Alternatively, they can sell the stock at $90 and get back their $900. Their loss is of $100 (10%), compared to the $1,000 (100%) lost on stock options.
Options trading is an excellent strategy for investing in stocks. This is why sophisticated investors love it. The returns can be extremely high. But so are the risks. Basically, with options, you can either win big or lose big. Of course, there are techniques which you can use to minimize the losses. However, the advice which is often given with investing is even more poignant for options trading: “Only invest money which you are willing to lose.”