Stocks move, Options move faster

Options are powerful investment tools.  They allow you to profit from rising stocks or from falling stocks by an incredible amount if you are right, but they also come with the risk of having you lose an incredible amount if you are wrong.

Let’s look at an example.  Say we find stock XYZ trading at $56.  We believe that this stock is going to go up in the short term so we could either buy the stock, or we could buy the call option on the stock.  Both ways could potentially be very profitable, but buying the option has a much higher profitability.

We could chose to buy the stock at $56 and as the stock goes up we make money.  So if the stock goes up to $64 we would make $8 on the trade or 14.28%, which is good, just not as good of a return as we would have liked.

Instead of buying the stock at $56 say we buy the $55 call for $3.  If the stock goes up the $64 the call would be worth at least $9 which would mean that we would make at least a 200% return on the option on the same move. Now wouldn’t you rather have a 200% move then a 14.28% return?  I would.

Now I know what you are thinking, “aren’t options risky” and “can’t you lose the entire amount you invest in them”.  Well the simple answer is yes, but all investments have some sort of risk.  You are fooling yourself if you buy a stock and do not believe it is a risky endeavor. 

Besides, risk can be managed through things such as position sizing, and stop losses.  All and all options, if treated correctly have the potential to greatly increase your profit potential in the market.

For more on stock options visit http://www.stocks-simplified.com/stock_options.html