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Options and Stock Return Comparison

By Edited Jun 28, 2016 0 0

Option is a derivative financial instrument from stock. It is more complex than stock, because you need to know many things like strike price, expiration date, or option Greeks. You can have more return with options but it is also more risky. Remember that higher return usually have higher risk. But if you know options inside out, you can minimize the risk. I will show you how you can win big with option. 

Let’s start with stock. Stock XYZ is currently trading at $100. If you want to buy 100 shares of XYZ, you initial investment will be $100 * 100 = $10,000. If the stock price rises to $110, then your investment will be $11,000. That is a $1,000 profit or $10/$100 = 10% profit. The profit does not include trading fees from your brokerage.

If you think XYZ price will go up, you need to buy XYZ call option at $100. This option is At The Money (ATM), because the current price is the same as the strike price. The cost or premium for that call option is $5 per share. To buy a call option which gives you the right to buy 100 shares of XYZ at the price $100 you will need $5 * 100 = $500. Therefore your initial investment in this position is $500 which is smaller than the stock initial investment of $10,000. 

Now if the stock rises to $110, you can buy the stock for $100 and sell it for $110. Your profit will be ($110*100) – ($100*100) = $1,000. That will make your total profit minus your initial investment of $500 will be $500. So your return will be $500/$500 = 100%. 

That is amazing, 10% compare to 100% for the same stock which goes from $100 to $110. With option you can make huge profit in short time like under a month. 

If the price stays at $100 then your stock won’t get any profit. Your option will expire worthless, because you don’t need to execute the option to buy the stock for $100 if you can buy the stock from the market for $100. So on that case, your loss is your initial investment which is $500. 
If the price drops to $80, then your loss in the stock is ($100-$80)*100 = $2,000. Your option loss will be the same as your initial investment which is $500. 

The conclusion, call option return is unlimited but the loss is limited. While with stock, your profit and loss is unlimited.  

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