Deep in the money options
Leverage is one of the best tools of profit. Leverage is what fed the real estate boom and continues to feed the popularity in forex trading. Unfortunately for equities investors, leveraging your stock purchases means borrowing from your broker. These margin accounts can be hard to get and require a significant account size which puts a large disadvantage on the small investor. For investors familiar with options, obtaining leverage is easier, cheaper and requires a much smaller investment.
Let’s assume that you want to buy 100 shares of Microsoft, thinking it will go up to $35 a share within the next year. In today’s market, this would cost you $2822 to control 100 shares. In the options market, it would cost you just $900 for 100 shares. With the same amount of money you could control 3 times as many shares. How does this work? Deep in the money options.
On the options market, you are simply buying the option to buy a stock at a certain price. If you think the price of MSFT is going to rise by January 2009, you can buy options for that expiration date. For example, if you wanted to control 100 shares of MSFT you could buy a lot, or 100, options of MSFT at a strike price of $20 per share for just $9. Basically you bought the right to buy MSFT stock before January 2009 for just $20 per share. Any amount over $20 per share is pure profit, you’re already up $9 on each option, which is the premium price you paid.
If MSFT were to fall below $20 per share, you’d lose nothing past the amount you paid for the option. You are paying a slight premium for the options, about .78 per option. However the option also decreases your risk. If you would have purchased the stock itself and it fell below $20, you could lose money past $20. In options, you can’t lose any more than you’ve put into each option so no more than $9.
In this scenario, buying a deep in the money option makes a lot more sense than buying a stock outright. You’re only putting $900 on the table to control 100 shares of stock while your profit is still maximized. While it will cost you an effective $78 over market price, you could almost make that back by putting the other $2000 you didn’t invest into a money market account.
Assuming that MSFT moved up to $35 per share like you expected, your $2822 investment is now worth $3500 while a $2700 investment in 300 MSFT options is now worth $4500. Invest less and make more.