Stock Options: Limited Loss and Unlimited Profit
Many people believe that the stock market can make you rich one day, but also make you bankrupt the next. Well, how eould you like to know about a method of stock trading that completely saves you from unlimited loss, but still leaves the door open for unlimited profit? That method is buying and selling stock options. How to trade stock options would best be explained using the following example. Lets say a person who thought that a stock selling in the market at 50 would decline to possibly 30, that person could buy a Put stock option. Not, however, that in buying a stock options, one should have some idea to what extent the stock might move. In inquiring what a Put stock option would cost, the person might receive a nominal quote of, say, $350 for a Put at the market for 90 days. Most options are negotiated "at the market," which means at "the current market," when the option can be obtained by the option-dealer. Suppose that the stock is selling at 50 and the quoted price of $350 is satisfactory to you. You enter your order: "Buy a 90-day Put on 100 XYZ [the name of the stock] for $350." If you are trading through your stock-exchange broker, the broker will give your order to an option-dealer who will contact one of their clients who sells options on that stock and will attempt to buy the option for you. When, after this contact or several others, the dealer has obtained the Put option for you, the dealer reports to the stock-exchange broker who gave him the order, and the broker in turn reports to the customer: "Bought Put 100 XYZ at 50 expires December 30 for $350." Let us say that the person who bought the Put option, expecting a decline in the stock, was wrong, and that the stock, instead of going to 30 (as expected), advanced to 70 and was selling when his option expired. The person would have lost the $350 that they paid for the Put option. Bear in mind that the limit of the person's loss was the cost of the Put option, or $350, no matter how high the stock rose and no matter how wrong the person was, and that the person would draw on the equity in the account to that extent only. Suppose, on the other hand, the person had sold the stock short in the market. The loss would have been 20 points and still no knowledge as to the possible extent of loss until the person covered the short sale. But in the purchase of the Put option the account would read: Bought Put on XYZ at 50 for 90 days: Loss $350 Remember, too, that no trade has been made in the stock, so no stock-exchange commission has been paid. A regular stock-exchange commission is charged by your broker only if a transfer of stock is made in connection with the option. On the other hand, suppose the person's judgment was correct and the stock declined to 30. If the person had instructed the stockbroker to buy 100 shares at 30 and exercise the Put option, the account would look like this: Sold 100 shares at 50 (through exercise of Put) $5,000 Total Receipts $5,000 Bought 100 shares in market at 30 3,000 Bought Put at 50 Cost 350 Total Cost 3,350 Profit on trade $1,650 The profit then would be almost 500 percent of the cost of the Put contract. The profit is the difference between the cost of the stock plus the cost of the Put option and the proceeds of the Put that was exercised. In all of these examples showing the use of options, the commission cost has been ignored. But at no time could the loss have been more than the cost of the option - $350 - and any stock-exchange commissions would have been paid out of profit or out of possible recovery of part of the premium which was paid.
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