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All trading basics

Do you know options?

As an informed investor, you undoubtedly know the benefits of owning shares, bonds, trust units and other instruments. But, are you aware of the advantages of options?

ADVANTAGES

An option can be used in many ways:

  • You can reduce or even eliminate the risk of loss
  • You can increase your returns in a flat or down market
  • You can anticipate future moves in the stock market
  • You can even take advantage of trends in the options market itself

MOST COMMON OPTIONS STRATEGIES

Some of the most common options strategies used by investors include:

  • Covered calls and secured puts, to invest
  • Purchase of calls or puts, to take advantage from a view in the market
  • Purchase of insurance puts, to protect a position

And, many more. This month, we will discuss the usefulness of the simple purchase of a put.

PURCHASING A PUT

If you short sell stocks because you think that the price of a given stock could soon drop, you might consider using options instead. However, short-selling a stock can be a risky transaction. Selling on margin allows you to obtain leverage on a stock and to increase your gains if your timing is spot on and the price of the stock drops. Then again, if you are wrong and the stock's price rises, you will increase your losses. Purchasing a put option gives you asymmetrical leverage, whereby if the price of the stock drops, you increase your gains, whereas if you turn out to be wrong, you limit your losses.

EXAMPLE

Ms. X and Mr. Y both think that ABC stock, which is currently trading at $20, will decline in the near term. Ms. X borrows 1.000 shares from her broker and sells them short, paying a 130% margin on the trade (the $20.000 she receives from the sale plus an additional 30% or $6.000). Mr. Y prefers to buy ten three-month ABC put options with a strike price of $20. These options cost him $1.000 ($1 per share).

Scenario 1: ABC drops to $10 within three months:

Ms. X will buy back her shares and pocket a $10.000 profit, for a return of 166.67% ($10.000 (the profit on the transaction) / $6.000 (the initial cost of the trade) = 166.67%).

Mr. Y will sell his puts and pocket a net profit of $9.000 for a return of 900% ($10.00 (the final value of the option) -$1.00 (the initial cost of the option) / $1.00 = 900%).

Scenario 2: ABC goes up to $30 within three months:

Ms. X will buy back her shares and incur a loss of $10.000, for a return of -166.67%. Note that her losses greatly exceed her initial investment. Mr. Y will let his puts expire, which are now worthless, and will have incurred a loss of $1.000 (or a 100% loss on his investment). He cannot lose more than the amount he initially invested.