There are several reasons why many individuals decide to invest in options. By the same token, there are reasons why others choose not to invest in options, and those reasons are addressed on other pages of the site.
For now, the three primary reasons why investors find options to be advantageous are the following:
1) Leveraging your money
2) Reducing risk
3) Insuring current stock investments
Leveraging Your Money
Options provide investors the opportunity to control a position with significantly less money. By investing in options, you can use less of your own money to control just as much money as if you were investing directly into the underlying stock. Let's take an example...
If stock X costs $50 dollars per share and you want to control 100 shares, you would simply have to buy 100 shares. In this case, such an investment would cost you $5000 ($50 x 100 shares), not including any commissions.
Now, let's say that one option for stock X costs $3. To control 100 shares of stock X by purchasing the option instead of the stock, you would have to purchase one contract, which equals 100 options. If one option costs $3, then 100 of them would cost $300. Again, not including commissions.
Purchasing the options provides a significant leverage point for your money. Two choices here...
Control $5000 worth of stock by putting up $5000?
OR...
Control $5000 worth of stock by putting up $300?
Obviously, positions can be taken with much less money if you decide to invest in options.
Reducing Risk
By leveraging your money with options instead of buying stocks, you reduce your potential risk in your investment. Using the above example, if you bought 100 shares of stock X, the most that you could lose in your investment is what you put in. In this case, the most you could lose is $5000. Quite a hefty amount.
One the contrary, if all you put into an options investment is $300, then the most you could lose is $300. Obviously, you are risking much less of your money.
Note: This applies only to long positions taken. This isn't applicable to short positions, in which case your liability could be unlimited.
Insuring Current Stock Investments
Most people who buy stocks simply do so without buying any protection - or insurance - for their investments. This can be risky. Like any other kind of insurance, this can be advantageous if you never end up using it. If you pay $400 a month for health insurance, it may be to your benefit to not get any health insurance at all if you never need to use it, or if your monthly expenditures on health and the like total less than $400 per month. However, the moment that you end up needing to use it, $400 per month can seem like a bargain. The same holds true for automobile, home or life insurance
The same also holds true for stocks. Options - especially puts - can serve as insurance for your investments.
Let's say that you buy a stock for $100 per share. Without any kind of insurance, you don't really protect yourself from the vagaries and variances of the market. Now, let's say that you buy a put for every share that you have your money in, and that each put option costs $4. Specifically, you buy puts that allow you to sell each share for $90. Your expenditure per share ends up being $104. What does this additional $4 expense per share end up accomplishing?
It ensures you that you will get at least $90 per share so long as you exercise your right to sell within the terms of the specific option. Now you may be saying to yourself that this may not be worth it. In some instances, you may be correct. Again, insurance can be an unnecessary expense if you never end up needing to use it. But what if the stock that you bought suddenly drops to $50 per share within just a few weeks? Or even worse - to $20 or $10 per share? Farfetched, you say? Well, in today's unpredictable economy and investment climate, nothing is impossible. During the dot-com bust, this wasn't uncommon. Many people lost fortunes because of such precipitous declines in their investments.
But if you bought a put option for each share then you could sell each share for $90 each. That's right! Even though each share could currently be worth $10, you are allowed to sell each share for $90 dollars. So instead of losing $90 or so per share, your loss is limited to only $14 per share. As such, a "premium" of $4 per share is a small price to pay for such an investment, don't you think?
If only these individuals who were once dot-com millionaires insured their stocks, they may still have their mountainside homes and luxury cars. Some had shares of technology companies worth upwards of $300 or $400 per share, only to see them hit single digits almost overnight.
Of course, you can also purchase options once you have already ensured yourself a profit in your investment, such as if you bought a stock at $100, it hits $200, and you buy put options that allow you to sell at $180 per share. That way you are ensuring yourself a profit and not only limiting your losses.
The stock market no longer operates the way it did decades ago. The advent of Internet trading and the machinations of globalization make investing a little less predictable and require the investor to proceed with more caution than ever before. Many companies are profitable and many continually have solid financial statements. But how many times has good news guaranteed that a stock will increase in value? Do principles of the "long-run" mean the same thing as before? It is not uncommon for the stock market to react unfavorably just because an unfortunate event happens in the Middle East or the Far East. Moreover, many of these events are unpredictable and the investor cannot readily take the appropriate positions prior to their occurrence. This is simply the way that investing works now. Everything is more interconnected, and there is much, much more to investing than just balance sheets and company news. And just because some events are unforeseeable doesn't mean the investor cannot be prepared and protected for when they happen. Insuring your investments with options is a very effective method to make sure you are not adversely affected for when you need to be protected the most.
If you are like most individuals, you have insurance for your health, your home and your automobile. So why not insure your investments as well?
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