Leverage
Leverage
On the other hand, an investor can often make (or lose) more money by purchasing options
rather than by purchasing the actual stock. This is the concept known as
leverage. The basic
premise of leverage is the same as a see-saw: The further you get from the center, or
fulcrum, the more dramatic the effects of movement. Leverage is explained in more detail in
Lesson 9, "Opening a Brokerage Account," but let's see how the concept of leverage
would work for an option.
Say you want to purchase 10 shares of XYZ Company stock, which is currently selling for
$10 per share. However, you believe that the price of XYZ Company stock will rise to $15 per
share. You could spend $100 to purchase the stock and wait. If the price should rise to $15,
your stock would be worth $150. Thus, you would have made a $50 profit; not bad for a day's
work. But let's say you decide instead to spend the money to buy 100 options at $1 per
option. These options grant you the right to purchase the stock at $11. Now, should the price
rise to $15 as in the first example, your options have an intrinsic value of $400. In other
words, for each share of stock you bought at $11, you would automatically make a $4 profit
off the $15 open market price. Since you have 100 options, you can make $400 profit
immediately by exercising your option.
Or, even better, say you bought the 100 options for $1 and decided not to exercise them at
all. Suppose you lacked the $1,100 needed to purchase those 100 shares at $11 in order to
realize that $400 profit. You could always find another investor who wanted to purchase XYZ
Company stock and offer to sell your options for $2 each (the dollar each you paid, plus a
dollar in profit). You would make $100 and a 100 percent profit on the whole deal. The other
investor would still save $200 on his or her purchase, and everyone would be happy. Well,
unless you stuck with buying the stock instead of the options. Then you would make only $50
off the transaction.
On the downside, however, let's say that you spend that $100 to purchase those same
options. And let's say that the other investor uses his or her $100 to purchase those 10
shares at $10 per share. And, let's say that the price of the stock drops to $9 and doesn't go
up. Since the price of the stock never reaches the strike price of $11, your options are never
exercisable; so you lose all of your $100. The other investor loses money also, but at least
his or her stock is still worth $90. Or, even more insulting, should the price of XYZ Company
stock stay the same, you've lost everything, whereas the other person who bought the stock
hasn't gained, but hasn't lost a dime either. You're still out $100.
"Wait," you say, "Didn't you tell me in the last section that the price of stock will almost always
go up eventually? So, I should just hold on to those options until such time as the stock does
finally go up. Right?" Well, in theory the answer is yes. But to even the playing field, options
have a limited time within which they must be exercised, or else they expire. The date when
they expire is known as the expiration date. Although this term is not a particularly technical
one, it is worth noting because it does limit the time within which an investor has a chance of
making money off the option.
As noted earlier, an investor can often make more money with options than with an actual
purchase of stock. However, the risks rise proportionately. The limited time frame and the
increased effect from changes in the price of the stock are summed up in a term called
volatility.
CAUTION
Volatility simply means that the more money you potentially can make with your
investment, the more risk you run of losing your money. It is because of this
increased volatility that options can be dangerous-even for seasoned investors.
For example, about three years ago I personally held several hundred options in a company,
which were worth thousands of dollars. I kept meaning to convert the options to actual stock,
but every time the stock rose a point, I made 10 times more profit than I would have had if I
actually owned the stock itself. Those kinds of gains are really addictive, even to a seasoned
investor like myself who knew the risks. At any rate, I never did convert the options. The day
the Russian ruble collapsed, the underlying stock value dropped by half. This was disastrous
for the stockholders because their stock lost half its value. However, I, as an option holder,
was completely wiped out because the price of the stock had dropped below the strike price.
My options were therefore completely worthless. Upset and in tears, not to mention broke, I
called my parents to bemoan my disaster. That memory keeps me out of the options market,
but you'll have to decide for yourself what your tolerance for risk is and act accordingly.
