Syndicate
Illustration of an Option
We are going to go through an illustration or example of what should be done when a person has a stock idea and they want to try out with options. Let’s say that we are bullish in XYZ stock and that we would like to make use of options in order to leverage the money that we have. The next step consists in deciding the strike price as well as the expiration date. We will say that XYZ is currently trading for $21 and we chose to purchase over a five month option with a $25 strike price. The option contract trades for a premium of forty cents per option contract. Given that each option contract is the same as one hundred shares of stock, it means that we would be able to manage one hundred shares of XYZ during the following five months and they expense for us would only be of $40. To be able to find out the breakeven price, we will need to add the option premium to the strike price, therefore it would be $.40 plus $25 which equals to $25.40. In case the option is still held to the expiration date, funds will not be made on the position unless XYZ goes over the $25.40. If you were interested in trading out of the position before the date of expiration, it is possible you would obtain a profit, but this would depend on how fast and how far XYZ moved higher throughout the path of the trade. However, we are trying to place emphasis on the trade in the manner investors would do so in general, which is to hold onto the option until expiration. One good thing about purchasing options rather than purchasing stock is the leverage a person is able to obtain. A person only has to spend a little bit of money up front in order to manage the one hundred shares. Rather than being required to pay out $2,100 in order to purchase one hundred shares of XYZ straight up, you would only have to pay out $40 now while utilizing these options. This is how it works. If XYZ were to go above that of $25.40, a decision will need to be made. There is the alternative of selling the option back to the market and obtaining a gain from it, or there use the option and convert it into real stock shares. If the decision is made to exercise, it will be necessary to pay the full stock buying price. In these circumstances, we would have to find another $2,500 in order to pay for one hundred shares of stock that was exercised. Keep in mind though that when doing this you are actually purchasing something that does not have actual value right away. You are going into a contract to purchase XYZ at $25 for every share when it could actually be purchased at $21 right now. So why would you do this then? There are a lot of people that do not want to fall down to $2,100 now in order to purchase XYZ however they are fine with just spending $40 for the opportunity that XYZ will obtain over the breakeven price of $25.40 in a matter of five months. There are a great number of people that would rather spend a little bit of money now and that hope the stock increases and turns into a profitable thing, instead of purchasing the stock at the actual market prices.