By Jason Fittler
Buying an option is buying the right to take some sort of action. You use them in the share market to increase leverage and reduce risk.
A Call option gives you the right to purchase a share at a certain price, by a certain time. This allows you to outlay a small amount of money now, but at the same time provide you with the benefit of any up side in the share. Your risk is the cost of the option.
Example: You want to buy 1000 shares in XYZ, current price is $10. But, you only have $1000. However, In 6 months time due to sale of other assets you will have $10,000. To lock in XYZ now and make sure that you benefit from any increase in the movement of the share over the next 6 months, you purchase the right to buy XYZ for $10 in six months using a Call option, this costs you $1 per option or $1000.
Once you have the $10,000 to hand you simply exercise your option and buy the shares for $10 each. The total cost of the shares is $10 plus the $1 call option total $11. As long as the share price for XYZ is above $11 you are in front.
If during the 6 months the price of XYZ falls to $5, then you simply walk away from the option losing your initial cost of $1 per option. This allows you to limit you losses to the amount of the options.
It is clear from the above example that you can also use these options to speculate on the market. If you buy options rather then shares you have better leverage and as such larger returns.
Take the above example; instead of buying $10,000 worth of shares in XYZ, you could purchase $10,000 of Call Options in XYZ effectively having exposure to 10,000 shares. If the price of XYZ moves up 10% the holder of the 1000 shares makes $1000. While the holder of $10,000 worth if XYZ options makes $10,000 dollars. You can see the attraction.
With options you need to get two things right, the movement of the shares (with a Call option the price of the share need to move up). Second you also need to get the timing right. In the above example you have 6 months for the stock to move up. Longer then this and you lose the value of the option.
Leverage… When you gear, you get better returns and bigger losses.
In the above example if you purchases $10,000 worth of Call options in XYZ and the price moved down 10% you would lose all of your money. If you purchased the shares you would lose $1000.
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