Introduction to Options? Getting Your Feet Wet

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Introduction to Options? Getting Your Feet Wet
It has been said that options are the most leveraged type of investment that you can own. Buying stock options is so powerful for two main reasons:

* Options have completely limited risk and unlimited potential for gain.
* Options are extremely leveraged (even more so than trading on margin).

With this said, lets look into each of those statements to learn why options are even better that trading just stocks in many ways.

Limited Risk & Unlimited Gain
Options are the ultimate equalizer. They allow even the most undercapitalized traders to trade like the professionals. When you write options you can never lose more than the cost of the option. Because of this, you can completely limit your risk to a level tolerable by you. So even if the price of the stock went to zero, you would only be out the cost of the option.
Here is an example, assume that you are looking at IBM stock. You want to buy in but the computer industry has been taking severe hits lately and you are reluctant. If you do buy the stock and the value of IBM stock goes to zero, you could be out a substantial amount of money (your whole investment). My realistically, if the price dropped by 50%, you would probably be pretty frightened by the sudden loss of half of the capital you invested in IBM stock. For fear of it dropping even farther and losing all your money, you might liquidate (sell the stock back) at a 50% loss.

With options, you don't have to worry about that as much. For a fraction of the cost of buying the same amount of IBM stock, you can buy an option on IBM stock. An option will allow you to have unlimited profit potential. At the same time, you could never lose more than the price of your option. Remember, you are paying much less for the option than you did for buying the stock, so this could be a great trade-off for you.

If options are so great, why isn't everyone trading them? Well, you give up one thing when you buy options... unlimited time. An option is only good for a limited amount of time: 1 month, 3 months, 6 months, a year, etc. When you buy the stock, you can sit on it for a couple of years if you think it will take that long to appreciate in value. On the other hand, with options, if the stock you have an option on has not gone in your favor during the time that you bought the option for, your option expires and the money you paid for the option is lost.

The Power of Extreme Leverage
Options give you the most leverage for your dollar. You put up the least amount amount of money and still have the potential to make unlimited profits. This is what makes options so awesome. Imagine the following example.

You are looking to buy an option on stock XYZ for let's say $25. The stock is trading at $10 per share and your option's strike price is for $12.50. The option you bought for $25 will control 100 shares of the stock. If you had to buy 100 shares of XYZ stock you would have to put out $10 times 100, or $1,000. Instead, you buy the option for $25.

If the price of XYZ stock goes down, the most you can lose is the $25 you paid for the option. If the price of XYZ goes up to $15 per share, you stand to make $250 on the option. On the other hand, if you had just bought the stock at $10 per share and sold it at $15 per share you would have profited $500. The difference, however, is in the percentage return. That is, what was your gain compared to your investment or risk.

In the case of buying the option, you spent $25 for the option. You made $250 on the option. Therefore, you risked $25 and made $250. That is a return of 1000% on your investment. If you had bought the stock, you would have had to put up (and risked) $1,000 and you would have made $500. That is a rate of return of 50%. You risked more and the rate of return was less! This is what we mean when we say that options are extremely leveraged: you put up very little money to control a large position and stand to make a great deal.