There are two different types of options. Calls and Puts. A Call Option gives you the right to buy a certain amount of shares at a particular price, some time in the future. There is no obligation. A Put Option gives you the right to sell a certain amount of shares at a particular price some time in the future. Again, no obligation. In order to have this right there is a small premium (cost) to pay. For example, lets say we are bullish on Ford (F). Currently the price is $10.60 and we think the stock will rise to $12 or more before the end of the year. We can buy 100 shares at $10.60 = $1060 investment. Or, we can buy an Option to buy the shares at $12 on or before the end of December for a premium of $0.71. Option contracts come in 100's. Therefore the cost paid would be $0.71 x 100 = $71. Now we are not obliged to buy them, but we have an option to do so at any time before the option expires at the end of December.
Lets say that the shares go down to $5. If we had bought the shares we would have lost $560. If we had bought the option we would have lost $71. The option has much lower risk.
Now, lets say the share price increases to $14. If we had bought the shares we would have made $1400 - $1060 = $340 profit. a return of 32%. If we had bought the option, then we can 'exercise' our right to buy the shares at $12 and then sell them at $14. Hence a profit of $200. (But we had the premium of $71). The profit of $129 ($200-$71) is not as good as $340, but the return on investment is $129 on $71. A ROI of 181%. The return is higher and the risk is lower. In this example the return in cash is lower, but look at the lower risk. If the stock goes to zero (and it happens) then the loss is $1060 versus the $71 still. Our maximum risk is never higher than the amount we paid for the option. In truth, what happens is that you would sell the option as the stock moved higher and not wait till expiration, as the value of the option would have increased as the stock moves higher.
Here's another example using MSFT. Lets say you are generally bullish MSFT but you don't know when it will go up. You just think it will. Most people would buy the stock and sit on it and hope. MSFT is currently trading around $23.41. Lets say you decide to buy 1000 shares. This means an investment of $23,410. Your risk is $23,410. That's what you will lose if the stock goes to zero. Or, we could buy a Deep In The Money Call Option. All that means is you will buy an option that does not have an expiry time for a long time out. Remember, you don't know when it will go up - just some time in the future. So we'll give ourselves plenty of time. A Deep In The Money Option just means, with the stock at $23.41 we'll buy an option 'to buy' the stock well below this level. For example, we could buy a Jan 2012 valid option with a strike price of $15. This means we have the option to buy MSFT at $15 on or before the end of January 2012. This will cost us $8.60 per option. If we add the $15 and the $8.60 together it comes to $23.60 - about the same as the stock price. Now to control 1000 shares we would buy 10 contracts.
(Remember a contract is 100 shares). So the cost is $8.60 x 10 contracts = $8600. Our risk has now reduced from $23,410 to $8600. That's about a third of the cost and a huge risk advantage.
Now we know the down side risk is reduced, but have we lost any upside. Let's say that over the next few months MSFT goes up $1. If we own the stock and the price goes up $1 then we gain $1 x 1000 = $1000. A 4.2% return on investment. With the option the price does not move up a full $1 on the option value, but it does move up 80cents. IE the option value increases by $0.80. So instead of $8.60 the option value is now $9.40 x 10 contracts = $9400. $9400 less our original cost of $8600 = $800 profit. A return of 9.3%. Again we have a higher return on investment and less risk. And, by buying Deep In The Money options we retain 80cents for every $1 increase.
(Changes in Option values vary according to how much time is left in the option as well a thing called volatility. Good on line broker sites will provide information on calculating the anticipated change in value). So we can see that owning the option gives lower risk and a higher return. But, what about dividends. If you don't own the stock you don't get dividends. That's right. But you still have the difference between the money you spent on buying the stock versus buying the option that can be sitting safely earning interest.
