The Millionaire Blog

I know many people who trade stocks. Most of the US house holds have stocks in various companies. Have you tried options?

Many people think Options are only for professional traders and the big boys. It is not so. Let me explain in simple terms what are the pros and cons of options.

Here is how the option works. Assume that you see a house in your street and the owner is planning to sell it retiring and moving to Florida within one year. The current market price for the house is $215,000. You go and talk to the owner Brad and tell him “Hi Brad; I would like to lock in this house for the price of $220,000; I will have the right to buy this house for this price for one year (i.e. till December 2006). For this I will pay you $2000.”. Now you and Brad come to an agreement; Brad gives you the right but not an obligation to buy the house till December 2006 at a price of 220,000. You have the right and not the obligation that is important which means if the house price goes down you don’t need to buy it at 220K.

Now in end of 2006, the house prices came up and now Brad’s house is now worth $235,000. Now you call a real estate agent sell it for 235,000 and give 220,000 to Brad and pocket a profit of 15,000 (minus your option premium of $1000). So your net profit is $14,000 on an investment of $1000. That is like 1400% return on your money.

If you had bought the house at 215,000 and sell it for 235,000 you might have made 20,000 or about 10% return on your money.

Let us consider the story of Bob Stock and Jim Option. Bob always invests in stocks and Jim invests in stocks and options. In January 2005 both Bob and Jim wanted to invest in Apple. At that time let us assume the price was about $40. Bob bought 100 shares of apple at $4000. Jim the wise guy bought 1 option of Apple at a strike price of $50 expiring in Jan 2006 at a price of $200.

Now let us see the technical definition of this option
· Number of contracts - 1 contract gives you the right for 100 stock
· Strike price – The price at which the option becomes “in money” meaning you start making profit from when the stock achieve this price
· Expiration date: Options are not for every; they have expiration date. The option bought by Jim expires in Jan 2006; that is if the apple stock does not go above $50 Jim loses every thing (in this case $200).

Now in December of 2005, Apple price doubled and is around $90 (including splits). Bob made $5000 and Jim made $4000. Bob’s return is 125% whereas Jims return is 2000% or Jim made 20 times of the money he invested.

Story of Bob Stock and Jim Option:-

Date Comments
Jan 2005 Apple stock is $40. Bob and Jim Likes Apple stock. Apple stock is $40. Bob buys 100 stock for $4000 Jim buys 1 option of Apple for a strike price of $50 ; he paid $200 for the option

Dec 2005 Apple stock is $90 (Adjusted for Split) Bob sells Apple for $9000 and gets a profit of $5000 from an investment of $4000. Jim sells his option for $4000 from an investment of $200. Return on investment for Jim is 2000% and for Bob it is 125%.

So what are the negative things of Options; one thing for sure is unless your bet is right you lose the premium and that is all. So your portfolio should contain both Stock and Options.