Stock Options – How can you profit from them?

What are Stock Options?

Stock Options share some similarities with futures contracts and with normal stocks, but they are inherently different.

Options are simply a contract, you do not own the underlying stock that determines the value of your options contract.  Unlike stocks which you can hold indefinitely, options contracts all have an expiry date, and the closer to the expiry date you get the less your option is worth.

As you do not actually own the stock only a promise to pay the difference between the stock price now and the stock price at some point in the future you will see that the options contract cost as little a 2% to 20% of the cost of owning the stock.

Stock Options are simply a vehicle to achieve a goal.  For those people who cannot use leverage to increase their total investment pot, Options are a cheap and effective way to leverage your invested capital.

The best way to understand options is to run through an example.

Stock Options  Versus Stocks

For example.  You have $1,000 to invest.

Strategy 1 – Buy the Stocks

You could buy 5 shares of Amazon Inc. (Ticker:AMZN)  at $200 per share.

Total Costs $1000

If Amazon moved up 10% over the next 2 months to $220.

Your profit would be ($220 – $200) = $20 per share.  5 Shares * $20 = $100

A 10% gain.

Strategy 2 – Buy Options on the Stock

You could by one “At the Money Call Contract” for AMZN with a strike price of 200 and an expiry date of May 21 2013.  The contract value is $10 per share.  Because you will control 100 shares with each contract and you buy one contract, your costs for the trade are $1000.

In options speak:

  • 1 contract means you will have control over 100 shares of AMZN
  • At the money means the strike price of $200 per share is equal to the actual stock price.
  • Strike price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date at which the option contract expires and loses all value.

In the same scenario as above the stock price moves 10% to $220.  The difference in price is $20 per share.  The contract was at a strike price of $200, therefore $220 – $200 = $20 profit per share.

Theoretical profit would be 100 * $20 = $2000.  A $2000 gain from a $1000 investment.  This means a gain of 200%.

I say theoretically because when you buy an option the clock starts ticking on the time value.  If the stock price took until the final month before expiry to move to $220, then you would have lost all of the time value of the contract which could reduce your profits.  However, if the stock had moved 10% in a single day you would have secured almost all of the 200% and also kept much of the time value in the stock.

What are the risks of options, compared to simply buying the stock?

If the stock price moves against you, you can lose the entire investment.  With stocks this is quite rare, stocks rarely move to zero unless the company goes bankrupt.

If the stock price does not move at all in the time period, your investment can also expire worthless.

The stocks needs to move in the direction you place the bet to make a profit.  If the stock price moves strongly your profits can be quite large.

Strategy 3 – Shorting a stock using options.

Using the exact same scenario but instead of us expecting the stock to increase in value we expect it to decrease.

AMZN has a current stock price of $200

You could by one “At the Money Put Contract” for AMZN with a strike price of 200 and an expiry date of May 21 2013.  The contract cost $10 per share and there are 100 shares in a contract.  Cost of investment is $1000.

In options speak:

  • 1 contract means you will have control over 100 shares of AMZN
  • “At the money” means the strike price of $200 per share has already been reached.
  • Strike price is the point at which the option will have a value (apart from the time value)
  • Expiry Date is the date at which the option contract expires and loses all value.

In this scenario the stock loses 10% in value to $180.  The difference in price is now $20 per share.  The contract was at a strike price of $200, therefore $200 – $180 = $20 profit per share.

Theoretical profit would be 100 * $20 = $2000.  This means a gain of 200%.

Options Summary.

Options are a complex instrument, but the more you understand them the more they make sense.  With experience you will see that they are an incredibly flexible investment tool.  However, before even thinking about trading options you will need to understand how to pick stocks, evaluate market direction and formulate a strategic systematic approach to investing.

Options are incredibly volatile and can very quickly lose your entire investment. Options are a numbers game and should only be used by advanced traders who have received specialist training in the topic.

3 COMMENTS

  1. this is very good information. some websites make you belive that you can make money very easy in stock options.

  2. In the stock option example scenario where the stock value decreases it states that you still receive a gain of 200 % the same amount gained in the example where the stock value increased 20.00. Is that correct or was that an error.

  3. Hi Angela, no this was not a mistake, as you buy a PUT Option Contract you make money when the stock price declines. Also the examples assume a $2000 gain and your original investment back.

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