History and purpose of stock options: Stock Options have been around since the early 70s, and they were created as part of the broader derivatives markets, in an effort to make global financial trading more efficient and more stable. Ultimately the derivatives markets have resulted in smoother stock trading, but they have even stabilized the way commodities such as crude oil trade from day to day, without Futures and Options contracts the daily fluctuations would be much larger and sharper.
A stock Option contract is like much like car insurance, the Option buyer has the insurance protection this contract offers in case of something unexpected happening, the Option seller acts like the car insurance company, profiting from selling this protection while offsetting his risks, and the stock Options premiums reflect market risk by changing all the time.
Stock Options Allow the Investor to Make Money in Any Market Trend:
A simple buy and hold strategy always makes money in the long run, but the returns may be so small, hardly outpacing inflation, on the above chart we can see the market went nowhere during a 3 year period. With stock Options however, the returns can be extremely high!
Benefits of trading stock Options:
Winning more – losing less: You all have heard about stock trading, and investing in the stock market, but have you ever wondered what’s so special about stock options, and why you should consider trading them, instead of trading actual stocks?
Well, here’s why; Options allow you to make money from different market environments, they allow you to profit even when the stock is not moving at all! In other techniques they allow you to trade with an unequal profit – loss potential.
For example, if you were a stock trader and bought 1000 shares of a stock priced at $10, you would have to pay $10,000. Then if the stock rose from $10 to $12 you would make a $2,000 profit, and equally if the stock dropped from $10 to $8 you would lose $2,000. That is a symmetrical or equal profit-loss relationship. With stock options however, you could control all 1000 shares of the above example with much less money, by buying 10 Call option contracts. And you would have an asymmetrical (unequal) profit – loss potential, so that if the stock rose from $10 to $12 you would make around $1,700, but if the stock dropped from $10 to $8 you would not lose $1,700! You would lose around 30-40% less than your potential profit, that’s around $1,150.
As you can see, compared to the stock trader, the stock option trader makes slightly less money when the stock goes in the desired direction, but he loses much less if the stock goes in the wrong direction! Imagine what this could have done during the stock market crash of the late 1990s, many people lost a lot of money unnecessarily while investing in stocks. An investor for example who had bought $100,000 worth of shares in a given company, and they fell 80% in value, actually lost $80,000! If he had bought Call options instead, he would have paid only a fraction of the money, maybe as little as $15,000 and even when the stock was 80% down, his Call options would only be down by 40% – 60%.
Instead of being left with just $20,000 out of a $100,000 investment, he would only have lost half of $15,000. If the stock rose on the other hand, the stock option investor would make almost as much as the stock investor. Do you realise that not only are stock options much more affordable, but they are also working in a non linear way, so they make you more money when you win, while losing you much less if you lose. That’s the nature of an unequal (or asymmetrical) profit – loss potential.
Generally, it makes great sense for even longer term investors to buy Call options rather than actual stocks, capital requirements are a lot smaller while potential for profit is really almost identical, while risk is almost 50% reduced! Also, profits made on option trades are exempt from capital gains tax!
Common myths surrounding options trading:
1) ‘When you trade options, time is against you and it’s very hard to win.’
Wrong! When you buy options, time is indeed against you, but it’s only a problem when you buy options that expire in less than 30 days. Buying options with longer expiry dates avoids this problem almost 100%.
2) ‘When you sell stock options you literally sign your life away, by taking unlimited risk.’
Wrong! Even when you sell stock options and you take the obligation to deliver or buy 100 shares of the given stock at a fixed price, the risk can still be limited. In reality, and contrary to what you read in many outdated books, all large brokerage firms actually allow you to buy back your written options at anytime, the open market allows this.