Recommended
Options for the Stock Investor
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Thursday November 20, 2008 |
The
Benefits of Options - Leverage
One
of largest benefits of using options is leverage. We know that options give the buyer the right, but not the
obligation to buy a stock at a fixed price for specified length of
time. The ability to
"fix" a stock price entry level for a specified length
of time has tremendous leverage implications. Using just a fraction of the capital required to buy the
underlying security outright, the option buyer is able to
participate in price movement.
Consider
this example. IBM
Corp. (IBM) stock is trading at $100. An investor believes IBM common stock will soon advance to
$120 and decides to buy one contract of the IBM November 100 calls
for a premium of $2. The cost of this transaction is just $200 plus commissions
versus buying the stock outright at a cost of $10,000 plus
commissions.
If
the investor is correct and IBM does rally to $120 the IBM
November 100 calls would advance to $20, that is a gain of 900
percent or $1,800! If
the investor had bought the common stock for a capital outlay of
$10,000 the gain would have been a handsome $2,000 but the return
on investment would have been just 20 percent. In this case buying an option was the correct course of
action.
Of
course leverage is a double-edged sword. If IBM common stock had remained at $100 through the life
of the contract or worse, declined below the $100 strike level by
the expiration date the option would have declined to zero and the
loss would have been 100 percent.
benefits
of options 
versatility
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