A question I often here about options trading is: Why bother learning options trading, its to complicated, just trade stocks. The answer is leverage.
When I was in grammar school I learned about levers and leverage in terms of moving rocks. A forty pound force moves a 400 pound rock, if you use leverage. As a student of science I learned that while levers and leverage looked magical and mysterious, but after I studied them I realized it was just applied knowledge.
In the financial world we also have instruments or tools which act like levers and provide leverage. And from the outside they seem magical and mysterious. But in reality they are just applied knowledge. So I wish to explain the leverage of options. It’s not magic, it’s knowledge. Let’s start with an example.
First Example: buying and selling a stock.
You buy Apple stock as an investment to profit on the appreciation of the Stock. You buy 100 shares at a price of $100 per share. This costs you $100 per share or $100 times 100 shares =$10,000. If Apple goes to 104$ in 30 days your profit is:
(104$-100$) times 100 shares=profit
(104$-100$=4$)x100=400$ profit
The return on your investment is :
Profit/Capitol Invested
400$/10,000$= 4% in 30 days
Risk and Benefit
Risk = Capitol Invested
Benefit = Profit
Your Risk= 10,000$
Your Benefit = 400$
You risk $10,000 dollars to make $400.
Your Risk/Benefit Ratio is
10,000$/400$= 25:1
In this stock example: You risk 25 times as much as you can make. In numbers your risking 25 dollars to make 1 dollar.
Second Example : Buying and Selling an Option contract.
You buy one option contract, giving you the “option” to buy 100 shares of stock at the strike price of $100, and you pay $10 per share or $1000 premium for this option.
This costs $1000
If Apple price increases to $104, the value of your option increases to $5 ($1 plus $4 in stock price increase)
So you sell the option.
Your profit is (5$-1$) times 100= profit
(5$-1$=4$)x 100=400$ profit
The return on your investment is:
Profit/Capitol Invested=return on investment
400$/1000$= 40% in 30 days
Risk and Benefit
Risk = Capitol Invested
Benefit = Profit
Your Risk= $1000
Your Benefit $400
You risk $1000 dollars to make 400$.
Your Risk/Benefit Ratio is
1000$/400$= 2.5 : 1
In this options example: You risk 2.5 times as much as you can make. Your risking 10 dollars to make 4 dollars.
The difference is leverage
Stock investment:
The return on your investment is :
Profit/Capitol Invested
400$/10,000$= 4% in 30 days
Your Risk= 10,000$
Your Benefit 400$
You risk 10,000 dollars to make 400$.
Your Risk/Benefit Ratio is 25 : 1.
Option Investment
The return on your investment is:
Profit/Capitol Invested=return on investment
400$/1000$= 40% in 30 days
Your Risk= 1000$
Your Benefit 400$
You risk 1000 dollars to make 400$.
Your Risk/Benefit Ratio is 2.5 to 1.
The difference between the stock investment and the options investment is leverage.
So as you can clearly see the reason people invest in options is leverage:
A small amount of investment Capitol goes in and a large profit is made.
- Smaller amount of investment capitol needed.
- Higher return on investment, based on same gross profit potential with lower capitol investment.
Discussion
Now the traditional important distinction between stocks and option is that stock purchases are not usually time sensitive, while options are by definition time sensitive assets which expire. But due to large amounts of capitol needed for stock purchases people sometimes borrow to finance the purchase and the terms of the financing may impose time limitations on the stock purchase. Now I don’t advocate you buy stocks or options as an investment vehicle. I think you should be aware of this investment vehicle because the lower capitol needed to enter trades allow people with smaller amounts of capitol to trade and profit from stocks. You should do your own due diligence before entering any investments.
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Formal Definitions.
Okay now that we have defined these important terms in a story, let’s review them before moving on to our next story and group of terms.
Capitol
The amount of money you invest in a business or a trade.
Profit
The sum which remains when you subtract the amount of profits from your costs to enter the trade.
Return on investment
The number you get when you divide your profit by your capitol invested, to give you a numerical percentage, which is useful when comparing investments of equal probability of success.
Risk
How much money or capitol you risk or can lose when you invest in a business or single trade.
Benefit
The amount of profit you expect to make from a business or trade.
Risk benefit ration
The amount of capitol or money at risk in a trade divided by the amount of expected profit.
Questions?
Place them in the comments below.
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