The greatest misconception about options is they are full of risk. But if you understand my secret technique called Superleverage, you’ll quickly realise just how low risk options really are.
Here’s an example…
Let’s say you’re looking at two different stocks, Widget Co. and ComTec. (I’m making up all these examples… as far as I know, there are no companies called Widget Co. or ComTec.)
First, Widget Co. In October, the stock is trading at $38. A good price, but you’re pretty sure the stock will be $50 at the end of the year. But “pretty sure” isn’t good enough for you to risk your money. After all, the stock could collapse.
How do you make sure you get the stock at a good price without the risk? Superleverage with options.
There are many things you could do, because there are many options to choose from. They come with a variety of strike prices and monthly expirations, and each of those options cost a different price—and therefore offer different opportunity to profit.
Let’s say you want to buy a Widget Co. January $40 call option for $500 (or $5 a share, since each option represents 100 shares). The price you pay for the option—in this example, $500—is called a premium. The premium depends on a wide range of factors, most importantly the actual price of the stock, but other factors play a role.
“Widget Co.” in this example is the underlying instrument, the specific security the option is for. The “January” is the expiration month for the option. The “$40” represents the strike price, the price you will pay per share if the option is exercised. And buying the call option means that anytime before the third Saturday in January, you can buy 100 shares of Widget Co. stock for $40 a share… no matter what the market price of Widget Co.
Meanwhile, ComTec is selling for $117 in October, but you think the stock is heading for a big fall come the new year. Rather than go through the expensive hassle of shorting the stock, however, you decide to buy put options instead. Again, options are available with a variety of strike prices and a wide range of expiration months, but you decide on the January $115 put option, also for $500. Any time between now and January you can sell (receive money for) 100 shares of ComTec for $115 a share.
You or your broker are monitoring your position daily. Friday, January 19 rolls around, and you still have not exercised your options (you haven’t sold them, either, but I’ll get into that later).You go on the Internet and learn, as we’d expected, that Widget Co. has just made a major announcement, and its shares have skyrocketed… to $72 a share. But, because of your option, you are able to buy 100 shares for $40. If you exercise your option, you will pay only $4,000 for $7,200 worth of stock. Then if you sell immediately, your option will be worth $3,200. That is its real, or intrinsic value. You only spent $500—since technically the money taken out of your account is immediately put back in (this is known as offsetting your position)—and you’re looking at a 540% return, minus commissions and taxes.
Congratulations! You just used Superleverage to turn $500 into $3,200. Throughout the transaction, your risk was known and limited.
By the way, if you had bought the 100 shares outright at $38 (for $3,800), your total return would also have been $7,200. But that’s only a gain of 89%. Still nice, but paltry compared to the return on the option. That’s the power of Superleverage.
Now you check ComTec, and see we were wrong (that happens occasionally). ComTec has also made a major announcement today. And its stock is edging towards $149. Because your option is to sell the stock at $115, it is useless… and worthless. At the end of the day, you have a 100% loss of the $500 premium you paid.
You may have lost $500, but that’s far better than if you had shorted the stock. If you had sold short 100 shares at $117 and the stock went up 27%, covering the short would have cost you $3,200 ($14,900 – $11,700).
Technically speaking, buying the option saved you $2,700.
But you don’t have to exercise options to make big profits. Options offer the promise of Superleverage—the potential to make large profits while strategically limiting your risk. That’s why it’s possible to make such huge profits in such a small time.
Editor, Options Hotline
Superleverage: Limiting Your Risk While Boosting Your Returns originally appeared in the Daily Reckoning. The Daily Reckoning has published articles on the impact of quantitative easing, bakken oil, and hyperinflation.
Business Insider Emails & Alerts
Site highlights each day to your inbox.