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Buying Options
The Smart Profits Report: Issue #292
Thursday, March 16, 2006
Buying Options: Like Owning a House Without Monthly Payments
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
“Trading options is like buying a house, only better…”
That’s what I often tell people who are trying to grasp the concept of options trading for the first time. They’re often confused about whether they have to exercise the options, or how they make money. What happens, they ask, if no one buys their option from them?
The fact is, buying options uses the same concept as a mortgage; but with options, you don’t have monthly payments. Let me explain…
Would You Pay Cash for Your House?
Most people buy the number of stocks they want and pay for them up front, in full. Or, they trade on margin, and only put up 50% of the full amount. This could be the equivalent of paying all cash for a real estate investment, or making a 50% down payment.
Let’s look at how using options could stretch your money even further, in this case. As a longtime reader, you know that utilizing call options in lieu of stock is the smart thing to do. It not only lets you control the same amount of stock, but it lets you do it with a much smaller up-front cash outlay. And with that smaller up-front cost, it lets you use the extra cash to invest in three, four, or maybe even five other stocks.
How does this compare to buying a house? When you buy a house, you sign a mortgage contract, make a down payment, and make monthly payments to the bank for a fraction of the house’s value. Even though you don’t own the house outright, you still get all the same benefits - you get to live it in, use the water, electricity, cable, phone, yard and anything else that comes with the house. Yet, you only have to pay a small amount each month to stay there.
With options, you get that and more. You only have to pay the up-front cost, just like a down payment when you buy the house. But with options, you never have to make another payment again until expiration (if you decide to exercise an in-the-money call option). You can control 100 shares of stock for every option contract you buy, but you never have to pay for the stock in full. You’re leveraging yourself by putting in a little to control a lot.
Buying Options: Excercising Your Mortgage
At the end of the option contract expiration period, you can either sell the option back into the marketplace (if there’s value left to it), or you can exercise the option and turn the contract into actual shares of stock. In that case, you’d have to pay for the balance at that time. Exercising options would be the equivalent of making a balloon payment on your mortgage contract. Just as you can sell options before they expire, you can always sell your house before the mortgage is paid in full.
The only investment difference between options and real estate is that options can become worthless if they’re out-of-the-money (OTM) at expiration. (Let’s hope that your house never becomes worthless!) The point is that you when you buy options, you get to control something very large for a small down payment. The premium that you pay for the options is similar to the down payment on a house. But options don’t require ongoing monthly payments.
For my money, options are simply the best way to use investment dollars. Why pay for something in full, up-front, when you can get all the same benefits for a fraction of the cost? That’s what options can do for you.
Good Trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Do you know the meaning of a “breakout?” It’s a price movement of a stock through an identified level of resistance or support, usually followed by heavy or increased volatility. Once the initial level of resistance is broken, it is then regarded as the next support level when the underlying asset falls back. This style is used within technical analysis. For more useful terms, please see our Smart Profits Glossary.
- Or check out Smart Profits #179, Breakout & Resistance: How to Anticipate and Profit From These Twin Concepts.
- Also, check out Smart Profits #282 by Steve McDonald, Option Trading Strategies - Option Plays That “Earn” Their Keep.
Related Articles:
- Trading Options: The Six Key Tools for Options Trading
- Stock Options: How to Buy $2,446 Worth of MSFT for $1,270
- Sell to Close Options - How “Patient” Trading Turned $8,000 into $192,000
