Let us see the main beauty of option in the stock market which make it very valuable investment asset. Something that make share market very unique compare to other investment. Understanding this benefit of option will make you understand a lot more of other derivative product available in the market.

This article is part of the “Understanding Options” series. The index page of the series can be found at http://www.sharetradingbyme.com/5/option-fundamentals/

Here are the main advantage of option as investment vehicle:

1. Option Can Be used as Insurance / Capital Protection

I would say this is the biggest thing about option. Let me illustrate with simple example: say you buy 1000 of Company XYZ’s stock for $25, hence your investment worth $25,000 at the time of buying. And something very terible happen and the stock is now worth only $5, meaning you loose $20,000 from this investment.

Now what if you buy the stock together with put option. Say you buy put option that give you right to sell at $25. Now, even the price is now $5, since you are guaranteed to be able to sell the stock at $25, then you will not loose that $20,000. In other word, your capital is protected.

Yes, there will be some cost involves, but that the same argument with the cost of your car insurance. The premium of insurance is charge every year regardless you make a claim or not.

But this factor is the one make sharemarket investment very unique. You cannot really buy a house and then buy an insurance that you will be guaranteed to sell at certain price, aren’t you ? Thanks to option, your investment in stock market can be “capital guaranteed” – you will not loss your capital! How good is that !

2. Option Can Be Used as Leverage.

With leverage, your investment goal can be achieved as higher speed. And option can do this leverage for you.

When you buy and hold a stock, for example that 1000 share of company XYZ above, you will want to sell it at higher price say you want to sell it when it reach $30 for $5 profit of $5000. So, your capital is $25000, you have profit of $5000 and that’s a return of 20%. Not bad return

But now, let say instead of buy stock, you buy a call option (that give you the right to buy at certain price) of XYZ at strike price of $25. It will cost you about $1 each, so you need to invest $1000. When the price reach $30, you simply exercise your option: buy at $25 and immediately sell it at $30 (current amrket price).

So, the effect is the same, you have profit of $5000 (of course less brokerage), but your capital is only $1000. So, the return is 500%. Imagine if you invest the whole $25,000 into this call option, then you make profit of $125,000. (500% return)

Yes, one thing really to consider is that option have expiry date, so if the price have not reached your price target before its expiry date, then you might loose the whole amount you invest on that option as the option could be expired worthless.

3. Option Can Be Used As Income Producing Activity

How about getting upfront income every moneth regardless of the movement of the market (because you received up-front payment already) ? Yes, this is possible with option. Instead of buying option, you can now “writing” option or selling it to other people. You become the “insurance company” discussed in point 1 above.

There are many strategy that you can apply to do option writing such as Covered Call, Naked Put, Credit Bull Put Spread, Condor, and other exotic strategy. SOme of these strategies require you not also write option also buy option to achieve specific goal.

4. Option Can be Used similar as Short Trading

Short trading is where you borrow stock from your broker, sell it now and when the price is go down, you buy from the market and return it to your broker. Basically making profit where the market down. This strategy is quite risky and highly regulated, but with option you just buy “put option” without any hassle at all.

With put option as already mention above, if the price went down from the strike price, you still have the right to sell on higher price.

By buying put option you will make profit if the price is going down, butt you are not exposed to the additional risk like Short Trading. Buying a call option and put option will carry the same risk.

Denis Kristanda