Why You Should Invest in Stock Options to Increase Your Returns?

Stock options have become a huge part of the market in the last couple of decades. The first options were offered in 1973 on 16 equities. Now you can buy or create options on over 2300 equities. Also known as derivatives, stock options allow you to control a large amount of stock with very little money. This combination of leverage and purchasing power makes the upside of stock options a very alluring investment and powerful tool for any investment portfolio.

What is a Stock Option?

A stock option is a contract written by someone who owns a stock that allows you the right but not the obligation to purchase or sell a stock at a set price in the future. The contract itself sells for a certain price just like a stock does.

Here’s an example. McDonald’s is currently selling for $54 dollars. I buy a contract to have the right to buy 100 shares of McDonald’s in three months at $58. So in three months time, if the price of McDonald’s is higher than $58, I exercise the option. The difference between $58 and the stock price is your profit, minus commission and the price of the option.

Puts and Calls

A call is an option that allows you to buy a stock at a certain price, while a put is an option that allows you to sell a stock at a certain price. With calls you are betting the stock will go higher, with a put you are betting it will go lower.

Difference between Stocks and Options

The difference between stocks and options are many. First, by owning a stock you own a piece of a company. You are entitled to dividends, if they are allocated by the board, and even a vote at the company’s shareholder meetings. Options don’t give you ownership in the company until you exercise them and buy the stock.

Risks

Secondly, there is a significant chance of loss. Options cost money to buy, and if the stock price doesn’t exceed the price on the option contract it’s worthless. You’ve just bought a contract worth nothing.

Leverage and ROI

The big lure of options is the incredible leverage you get by purchasing them. For a limited amount of money you can control a large amount of shares. If you then exercise the winning option and immediately sell the securities you have a huge win when it comes to your return on investment (ROI). This leverage is what makes options so attractive.

As with any investment, there is a mixture between risk and reward that must be factored in before adding it to your investment portfolio. Correctly researched and purchased stock options can provide terrific ROI and leverage as well as diversifying your investments.