Innovated Tips from Better Trades

Leveraging your buying power for the big move

Let's imagine you have a strong feeling a particular stock is about to move higher. You can either purchase the stock, or purchase "the right to purchase the stock" (but not the obligation), otherwise known as a call option. Buying a call is similar to the concept of leasing. Like a lease, a call gives you the benefits of owning a stock, yet requires less capital than actually purchasing the stock. Just as a lease has a fixed amount of time, a call has a limited amount of time as well and can expire worthless.

Let's look at an example. XYZ stock is trading at $90; it would take $9,000 to buy 100 shares. If you buy the stock, your ultimate downside risk, is $9,000. Should the stock drop to $70, your investment will only be worth $7,000. On the other hand, if the stock goes to $110, your investment will be worth $11,000. Either way, there is a lot of money at risk.

Now, let's see what would happen if you bought call options instead of the stock. In early July, you decide to buy one September 90 Call for $7. Since each contract controls 100 shares, you bought the rights (but not the obligation) to purchase 100 shares for $90 per share. The price, $7, is quoted on a per share basis. As such, the cost of this contract is $700 ($7 x 100 shares).

If the stock stays at or below $90 before the options expire, $700 is the most you could lose. On the other hand, if the stock rises to $110 at expiration, the options will be trading around $20 (current price: $110 - strike price: $90). Thus, your $700 investment will be worth $2,000 ($20 x 100 shares x 1 contract).

If the stock price increases, the option gives you two choices: sell or exercise. Many investors choose to sell because it avoids the substantial cash outlay of buying the shares. In the example above, you would pay $9,000 ($90 x 100 shares) to buy the stock when you exercise the options. At a market price of $110, your shares would actually be worth $11,000. Not including commissins, you would have made a $1,300 profit on your $700 investment ($2,000 - $700).

By selling the options, you realize the same profit without spending the money to buy the shares. With the stock at $110, the 90 calls would be worth $20 each. Thus, each option contract would have a value of $2,000 ($20 x 100 shares). Not a bad return for a $700 investment! Selling rather than exercising also avoids the extra commission incurred by buying the shares. For example, when you sell the options, you pay a commission. When you exercise the options and buy the shares, you pay a commission to buy the shares. Later, when you sell the shares, you pay another commission.

The scenario described above is a great example of the leverage that options provide. Just look at the returns on a percentage basis.

	Purchase Price	Sale Price	Profit (Loss)	% Gain (Loss)
Stock Price	$90	$110	$20	22.2%
100 shares of stock	$9,000	$11,000	$2,000	22.2%
One 90 call	$700	$2,000	$1,300	$186%

As the chart above demonstrates, if you bought 100 shares of stock at $90, you would be putting $9,000 at risk. If you sold the stock when it $110, you make $2,000 on your $9,000 investment, a 22.2% return. In contrast, investing $700 in call options only puts $700 at risk. In this case, the return is 186%.

Now, let's see what happens when the stock drops.

	Purchase Price	Sale Price	Profit (Loss)	% Gain (Loss)
Stock Price	$90	$70	($20)	(22.2%)
100 shares of stock	$9,000	$7,000	($2,000)	(22.2%)
One 90 call	$700	$0	($700)	(100%)

While this scenario looks scary on a percentage basis, when you look at the raw profit/loss numbers, it's clearly relative. If the stock drops, your call may expire worthless, but your loss is limited to your initial investment, in this case $700. In contrast, the stockholder sustains a far larger dollar loss of $2,000. When you compare the limited downside and the unlimited upside potential of call options, it easy to see why they are such an attractive investment for bullish investors.