I understand that buying an option gives you the right to sell a certain stock at the strike price, but what is the point of this? How can you profit from guessing right, and is there any advantages to options that stocks don’t have?
In: Economics
Let’s imagine a stock that’s currently trading at $50/share.
To buy a bundle of 100 stocks would cost you $5,000. If the stock’s value increased to $75/share, you could sell your shares for $7,500. You would make a $2,500 gain on a $5,000 initial investment, or a 50% return. On the other hand, if the stock’s value dropped to $25/ a share, you would lose $2,500.
Now let’s consider how options work. To buy a call option (giving you the right to buy a certain number of stocks, at a fixed price) on 100 stocks with a strike price of $50/share costs **a lot less** than $5,000. For purposes of this example, lets say those options cost $500. These options are **not** ownership of stock; you’re literally paying $500 just to have a guaranteed price, and you still need to come up with the $5000 to buy the stocks themselves. (though you could borrow the money and then immediately sell the stocks if they’re worth more than the strike price)
So now, you’re buying call options on 100 shares of stock with a strike price of $50/share for $500. If the stock price goes up to $75/share, you would make a $2,500 gain on a **$500** investment or a **400%** return. On the other hand, if the stock price goes down, *no matter how much it goes down*, you can only lose the $500 you paid for the options.
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