Recommended
Options for the Stock Investor
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Thursday November 20, 2008 |
The
Benefits of Options - Limited Risk
For
the option buyer risk is always limited to the premium paid. This is a tremendous benefit. Whenever an option is purchased the holder knows they
cannot lose any more than the original investment.
Let's
return to our IBM Corp. example. Our speculator believes that IBM stock is about to rise and
buys one IBM November 100 call for a premium of $2. With this purchase he effectively controls 100 shares of
IBM Corp., an investment of $10,000, for just $200. His speculation proves incorrect and IBM common stock falls
to $95 by the expiration date. The option premium declines to zero because the right to
buy IBM common stock at $100 is not useful when the common stock
is trading at $90. The
speculator chooses not to exercise the option and loses $200. If he had purchased the stock the loss would have been $500.
The
option buyer will take comfort in the thought that during the life
of his option IBM shares may rise or fall substantially but he
will never lose more than his original investment of $200.
This
benefit is even more pronounced when an investor moves to the
other side of the market. If an investor is bearish for IBM Corp. and decides to
purchase puts he can take comfort in the fact that his initial
investment is all that is required to effectively participate in
the downward movement of IBM common stock. Shorting stock requires
a margin account, and margin calls on a short sale might force the
investor to cover his position prematurely. As a put buyer, the
investor can hold the position through the option's expiration
without incurring any additional risk.
versatility
standardization
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