How can options make more money than stocks if they are both based on the same thing?

160 views

How can options make more money than stocks if they are both based on the same thing?

In: Economics

The value of options isn’t directly fixed to the price of the underlying security, instead, the option only has value if the underlying security is trading at a more favorable price than the strike price, or/and there is speculation that the price will move that way.

For example, a call option with a strike 10% above the current trading price and expiring that week will probably trade at a very low price. However if someone buys that option and the security suddenly jumps at least 10%, any further movement will create a late profit for the investor. But there’s also the risk that such a price move doesn’t happen and the investor loses their entire investment in that option.

The same way sports betting can make more money than the actual sport. Options are essentially gambling on what a stock/bond does.

Options are basically non-refundable but tradable deposits to buy a stock at a certain price by a certain date. They usually cost a fraction of the cost of the actual stock.

Say the stock is at $100 and you buy one share and it goes up to $110 a month later. You sell and you make $10

Say instead you can buy an option to buy the stock at $105 for $1 per share, with the option expiring in a month. You buy 100 for $100. The stock goes up to $110. You can then sell the options for $5 each (the difference between the agreed price and the stock price) so clear $400 profit. Yay!

On the downside – if the stock price is below $105 at the contract expiration the option is now worthless and you lost your $100 deposit. You haz a sad.

In other words – for a given amount of money an option contract gives you *temporary* control over a significantly larger number of shares, but at the risk that you’ll lose all the money you put down.

For someone who isn’t an investment bank trading options is, in effect, indistinguishable from gambling. And the “person” you’re betting against is a host of enormous investment banks with entire buildings full of math and economics PhDs working 80 hours a week to feed data to teams of some of the best software developers on earth who write highly optimized algorithms that run on special order servers that are located as physically close to the market as possible to reduce the number of microseconds it takes for the trading signals to travel from the computer to the trading floor, for a system that’s able to read and analyze any new market information and execute thousands of trades based on it in the time your computer takes to refresh a frame on your 144hz monitor. The way you make money against that betting opponent is to take significantly higher risks than them.

TL;DR: Options are a high risk form of gambling and while you can make money with them they are mostly a very efficient way to lose a lot of money very quickly.

Imagine a stock is $10/share, it goes to $20/share, so you can spend $10 and make $10 by buying and selling it. Now if the stock instead went down to $9, you have lost $1

Or you can buy an option, you pay $10 for the right to buy 100 shares at $10 (you lose the $10 in either case). So you spend $10 on an option to buy 100 shares at $10, and then it goes up to $20, so theoretically, you could buy 100 shares at $10 for $1k, and then immediately sell them for $20, instantly getting you $2k (well, $1990 when you subtract the cost of the option), you’re broker will loan you the $1k for an instant to let this go through, so you don’t actually need $1k.

Now, with an option if instead the stock went down to $9, it would be worth -$900. However, it’s an option so you actually just lost $10 you spent in the first place.

Options and stocks aren’t based on the same thing. A stock is a stock. It isn’t based on anything. It is a share of a company. You own a chunk of the company when you own stock.

An option is the right but not the obligation to purchase a stock/sell a stock at a particular price. There are two kinds. Calls are a bet you buy when you think a stock might rise. Puts are a bet that the price will drop.

An option only has value at the strike price and above for calls and at the strike price and below for puts. Options also have an expiry date.

The writer of the option is betting that the option will expire worthless. The writer gets paid when you buy the option, that’s how they make money, unless they are wrong on their bet of course.

In the case of Gamestop (GME), buying call options at $300 strike in Dec. 2020 was dirt cheap. Maybe a dollar or less a share because no one believed at the time that the shares would have any value. A reddit user /u/deepfuckingvalue made 30 million on gme buying shares and option. Probably 20 million of his profit was options that cost him a couple grand.

DM me for an in-depth and tangible explanation for how options really work, and how you can use them

Let’s say a stock trades at $50. You think it’ll be worth $60 in 2 months. You can buy shares for $50 and if it rises to $60 you’ve profited 20%.

Or you could buy an option to purchase shares at $55 2 months down the road. When the stock trades at $50, that might only cost you something like $2 a share (x100 shares). If the stock actually hits $60 then, you’d pay $55 for shares worth $60 and have an immediate 250% profit.

So with $200 you could buy 4 shares, make 20% and profit $40.

Or you could buy options on 100 shares, execute the option and immediately sell shares for $60 that cost $55 and profit $500. And if the stock shot up to $100, you’d turn your $200 into $4,500 (very rare, but basically what some WSB apes did on GameStop).

But the risk is that if the stock doesn’t move in the way you think, you could end up losing your whole $200, vs. the stock just going down in value but could bounce back if you hold longer term.

Options allow you better leverage. If Stock X is currently at $100 and I think it’s going to be at $115 in 3 months, if I by $1000 worth of stock and then sell when it hits $115 I made 15%. But if I buy an option to buy at $110 it may only cost me $2 per option, so I buy 500 options. Now if it hits $115 I make $1500 ($5 of value, minus $2 of cost, so $3 per option at 500 options), which is 150%, 10x as much as I made buying the stock.

The trick, of course, is that my losses aren’t capped and it’s easy to lose my entire investment. If instead of $115 the stock goes to $109, the person that bought stock still made 9%, the person that’s holding onto 500 options to buy at $110 when anyone can buy at $109 is out of luck and lost all of their money.