Example One - Basic Call
You did your research on Apple and decided that the stock price
will increase dramatically soon. You want to invest approximately
$2000, but the stock is very expensive (currently trading at
$121.51). Your $2000 will only buy you about 16 shares. You want
more leverage. So you look into options for Apple. You find that
the May $125 Strike Price Call Option will cost you $470 per option
(stated as $4.70). You stretch it a little and buy 5 option
contracts costing you $2350. Sure thing the next day, Apple shares
jump up to $126.17. You look at your option and its now worth
Do some quick math and your profit is $475. That is, 5 contracts *
($565 - $470). Now if you had bought the stock directly, your
profit would have been around $88 because remember that $2350 would
have only bought you 19 shares. That is the power of options...if
you get it right!
$121.51 * 19 = $2,308.69
($126.17 * 19) - $2,308.69 = $88.54
||$470 * 5 = $2,350
||($565 * 5) - $2,350 = $475
This example shows a really nice profit. But remember that you
could have easily lost $475 if Apple did not perform well. If
you had bought the stock, you would have lost only $88.54 and you
would have the luxury of holding onto the stock and wait for it to
appreciate. With options, you don't have the luxury of time.
By the way, I did not make up these numbers. This is how the it was
on April 23rd, 2008.
Example Two - Basic Put
You have a fairly bearish sentiment on VMWare. The ticker is VMW.
You know that people are really cutting back on their technology
budget these days so you believe VMW will have something bad to
report on their earnings. VMW is currently trading around $32 so
you go ahead and buy some put options. You scan the option table
and decide to pick the May Put where the strike price is $31. It
costs you $1.85 per contract (remember that you have to multiply by
100 to find out what you will actually pay from your pocket!).
Because it's only $1.85 you purchase 10 contracts. So your cost is
$1,850 plus commission.
The next day you find out how lucky you are (or smart you are
depending on how you want to look at it). VMWare reports terrible
earnings and their stock price dips to $26! You hate to see the
company do bad but you love to make money. You option is now worth
$5.4. I'm sure you can do the math by now. Your net profit is
$3,550. Not bad huh?
|$32 * 60 = $1,920
| $1,920 - ($26 * 60) = $360
||$185 * 10 = $1,850
|| ($540 * 10 ) - $1,850 = $3,550
For comparison purposes, I've assumed you have shorted the
stock. So the first row in the table shows what the profit
would have been if you closed your short position at $26/share.
Example Three - Call gone wrong
You got a nice tip about a little known company poised for a big
bounce. The ticker is VOL. You buy some call options where the
strike price is $7.5. You buy it at $0.45 (again multiply by 100 to
get $45). So you sit and wait for the thunder to come rolling in.
You soon discover that your tip was bad. VOL is not behaving as
expected...in fact it is declining in stock price! you put in your
sell order for the options but you can't sell them. Why? Because
the volume is zero! Somebody sold you a bum option when the
sentiment was high. But now nobody likes it and nobody is willing
to take those options off your hands. You're stuck!
But wait; you still have some time before expiration. Maybe the
stock will pick up and people will start trading in these options
again. Maybe...and maybe not. This is the risk you sometimes take
when dealing with options. I suggest you stick to the ones where
the volume is high; at least a few thousand a day. So you have a
reasonable chance of getting out if you want.