Derivatives

How can you dramatically increase your investment return?

Let's say you are a holder of European Call option (European option can be exercised only on the expiration date) on XYZ company stock with a strike price of $90. Suppose the current stock price is $87, the expiration date is three months and the option price is $4. If the stock price on the expiration date is more then $90, you will exercise the option (you will buy the stock that costs more than $90 for $90). Let's say, that the stock price is $100. By exercising the option (buying the stock for $90) and immediately selling the acquired stock in the market for current price of $100 you'll gain (for demonstration and simplicity we are ignoring transaction costs in these calculations):

$100 - $90 = $10.

If the initial cost of the option is taken into account the net profit is calculated as follows:

				profit on exercise = $10 
				cost of option     = $ 4
				-------------------------
				net profit         = $ 6

The following picture shows this case in Investor:

Your net profit is 150% of the up-front premium (the price of the option):

$6/$4*100% = 150%.

If you initially had purchased the stock XYZ itself instead of option, your gain would have been:

$100 - $87 = $13.

The following picture shows this scenario in Investor:

In this case your net profit would have been only 15%:

$13/$87*100% = 14.94% ~ 15%.

150% vs 15%, incredible! That's the answer to the question above about dramatically increasing your profit!

But wait, - you say, - something is wrong here, there is no such a thing as free lunch!
And you are right. What you pay for this huge increase in profit is the risk level you have exposed yourself to. What is the risk? You risk to lose 100% of your initial investment, or the amount you paid for the option. If the stock price will fall below the strike price of $90, you will not exercise the option (there is no point in buying for $90 the stock that has a market value of less than $90) and you lose whole initial investment of $4 that you paid for the option. In this case your loss is 100% of initial investment. This case in Investor is shown below:

If you initially had purchased the stock XYZ itself instead of option and stock price had fallen to $82, your loss would have been:

$87 - $82 = $5.

This case in Investor is shown below:

Your net loss in this case is only 5.75% (of initial investment of $87):

$5/$87*100% = 5.75%.

See the difference - loosing 100% or 5.75%? that's the risk of playing with options, it's like playing in casino, you win a lot or lose everything.

So, in deciding of whether to invest in options or not you have to decide the comfortable risk level, risk you are ready to expose yourself to. On the bright side is that your downside risk is limited by option price ( your maximum loss is price of option), while your upside profit is theoretically limitless, you can gain any huge amount depending on underlying stock price at exercise time.