Using the leverage of options

Options are mostly misunderstood but are a very important tool that the average investor could use to enhance their returns. Basically, options are a negotiable instrument, can be traded, that give the buyer the right, but not the obligation, to buy(call) or sell(put) the underlying stock (or futures contract) at a specified price until their expiration. In other words, options are tradable insurance contracts. An investor can purchase an option as insurance against decline in the stock or a rise in the stock. There are many ways to trade options, some are very complicated, but only the basic methods are outlined here.

Advantages of Options

Options have a few advantages that every investor should be aware of, such as high leverage, lower overall risk, more versatility and ability to generate extra income. Since options are a tradable insurance contract, their value fluctuates in direct relationship to the underlying security. The price of the option is only a fraction of the price of the security and therefore provides high leverage and lower risk. There are many ways to trade options, some are very advanced, but most investors only need to be familiar with the basic methods in this article.

The Basics of Options

An option is described by its symbol (call letters), whether its a put or a call, an expiration month and a strike price.

A Call option is a bullish contract, giving the buyer the right to buy the underlying security at a certain price by a certain date.

A Put option is a bearish contract, giving the buyer the right to sell the underlying security at a certain price by a certain date.

An expiration month is the month of which the third Friday is the date that the option contract expires.

A strike price is the price that the buyer can either buy (call) or sell (put) the underlying security by the expiration date.

Both Calls and Puts can be both bought and sold in the open market.

Basic of Options Trading continued

A premium is the price that is paid for the option.

The intrinsic value is the difference between the current price of the underlying security and the strike price of the option.

The time value is the difference between current premium of the option and the intrinsic value. The time value is also influenced by the volatility of the underlying security.

All options expire worthless and the time value declines until expiration date as the contract loses its time value.

The seller of the option contract is obligated to satisfy the contract if the buyer decides to exercise the option.

Trading Options

We will start with an example using IBM as the underlying security. At the time that this article is written, IBM is trading for $72.00 a share. We are bullish on IBM and we think that it will go to $85.00 a share very soon. Buying a 100 shares of IBM will cost $7,200.00 and if we sell our position at $85.00 a share, we will gain $1,300.00 or 18% return. We will have $7,200.00 at risk if we take this position for a potential of 18% or $1,300.00 profit.

Using options, we can buy 1 contract of IBM call options with an expiration that is at least two months ahead and a strike price that is close to current price of the underlying security. 1 contract represents 100 shares of the stock, Call option is a bullish option, two months till expiration gives us some time for a quick move and by buying an option with a strike price that is close to the current price of IBM allows us to get the full potential of the Intrinsic value.

IBM Aug2 70.0 C is the long version of IBMHN, both are symbols for the specific option that we purchase. IBM is the symbol of the underlying security, Aug2 is the expiration month of August 2002, 70.00 is the strike price and C stands for Call option. This option is selling for 3.70 at the time of this article.

$72.00 (current price on IBM) minus 70.0(strike price) is 2, which is our intrinsic value. 3.70(option premium) minus 2(Intrinsic value) gives us 1.70, which is the time value.

If IBM gets up to $85.00, as we think it will, the Intrinsic value of this same option at that point will be 15 (85-70). That means that if IBM gets up to $85.00 a share, our option premium would be at least 15 plus a bit of time value, depending on time till expiration.

One option contract will cost us $370.00 (3.70 times 100) and if IBM goes up to $85.00, we could sell our option contract for at least $1,500.00, maybe more. We will have $370.00 at risk if we take this position for a potential of 305% or $1,130.00 profit, plus what ever time value is left in the option. Don't forget that this option will expire worthless if not sold or exercised by the expiration date.

As you can see, options can offer much higher returns with less risk for the same trade.

This is just one example of using options to increase your returns. There are many more strategies and ways to use options and we encourage you to explore them further.

Risks of Options

All options expire worthless, so you must close your position before the expiration date or you will lose all of the premium.

Time value portion of the option premium decreases gradually until expiration date.

There are many other intricacies of options trading that the investor should be aware of. This article is only an introduction to options trading and there is a lot more information out there. We will keep posting articles about options trading.