Example #2 – Increase your Risk, High Leverage Positions – Buying Calls.
This is where things get a little scary for some people. I would like to disclaim that if you do not respect options – You can get destroyed. I am ONLY going to write one technique and try to completely scare you out of another.
You have $1000 to invest. You are eyeballing a stock that is selling for $10 a share and you are confident that it is going to go up to $12 a share within a year. “Call” options with a strike price of $11 and an expiration date 12 months from now are selling for $.25.
You have two ways of approaching this company and owning a security: Buy Stock or Options. We will compare the two options:
For our two comparisons assume the stock does go to $12 a share before the end of the year, just as you predicted.
Stock = $1000 / $10 a share = 100 shares * $12 (New market price) = $1200 (20% gain)
Option = $1000 / $25 an option (Because all options are of units of 100 shares, thus .30*100 = $30) = 40 Options which are are now have the ability to buy a stock for $1 under market price. 40 options * 100 shares = 4000 shares * $1 a share profit = $4000 (300% gain)
Assuming the stock never goes above $10.80 during the year and close that 12 month period at $10.50.
Stocks = $1000 / $10 a share = 100 shares *$10.50 (New Market Price) = $1050 (5% Gain)
Options = $1000 / $25 an option = 40 Options – If they expire today and the option is to buy stock for more than it is worth – what do you think the option is worth? $0. = –$1000 (100% Loss)
Example #3 – Highest Possible Risk, Highest Leveraged Positions – Selling Naked Calls.
You are selling the right to buy a stock at a price, a stock you don’t own. It is referred to as “naked” because you don’t own the security. Let me show you why this is the riskiest option trading you can do.
You have a trading account with $100,000 in it. You think a stock is going down. The stock is currently trading for $10 a share. You sell a “Naked Call” to “CALL” (buy) the stock for $13 a share with an expiration of 3 months. You receive $1 a share for this option. You sell 100 options (10,000 shares) – your account balance is now $110,000 because you received $10,000 for this option. 3 weeks later the company has amazing news that sends the stock SOARING. The stock SKY ROCKETS to $23.50 a share at the end of the 3 week. The person holding the option executes the option. They are now going to buy 10,000 shares from you at a price of $13 a share.
How it works on your end. Behind the scenes, without your consent: You purchase with your account’s balance 10,000 shares at $23.50 (market price) and instantly sell them for $13 a share to the option holder: -$235,000 + $130,000 ($13 a share from option executor) = –$105,000 Loss. Your account balance is now $5,000 (was $110,000). You just lost $105,000. When you hear Naked Calls think this, Highest Leverage, Highest Risk, Gambling with your Future, Life Destroying.
Boy this is a long article. Why do I want you to know about options?
Options open a whole new world to traders. They can help you mitigate loss, increase leverage, or gamble away your life.
I would like to say that increased leverage can be a good thing, especially for those who are trading with small amounts of money. Just realize that with leverage you are open to both big gains and big losses. If you are currently trading on margin and paying money to a broker to borrow capital – you can use options as a way to use less capital to purchase a similar amount of leveraged power without borrowing money. Remember to be safe!
Disclaimer: Always consult a Professional for Investment Advice. All examples were to illustrate only the mechanisms of option trading and do not represent actual trading numbers, results, or trends. Trading either stocks or options can result in losses and exposure you to risk. I am not a License Professional Financial consultant.