Page 247 - A Canuck's Guide to Financial Literacy 2020

247

Jim would profit on his American Airline put if the premium paid is lower than the difference
between the strike price and the stock price. Jim purchased the put option for $1.50 with a
strike price of $50. The current price of American Airlines is $45 at expiration. The option is
worth $5 meaning the Jim has made a profit of $3.50. He can choose to exercise the put
contract and sell his shares at $50 each when the stock price is trading at $45.

Usages of Options

Speculation

If you buy an options contract, you’re betting on the direction of the security.

This kind of bet requires sophisticated knowledge of financial markets and a high-risk
appetite and comfort with volatility. To become a successful options trader, you must
understand and predict why a stock will go up or down and how much the price could
change. You have to be mindful of macro and global fundamentals.

Buying options also allows you to use leverage. Leveraging allows you to pay only a small
percentage of the share, $10 instead of $100, for example. Leveraging therefore allows you
to make substantial profits with a minimum investment. If your predictions are accurate, you
could double or triple your initial investment. If not, you could lose your initial investment
entirely.

Options trading can be extremely risky.

Hedging

Think of it as using options as an insurance policy to protect your stocks against a
downturn.

Why buy options if you’re so unsure of your stock pick? This strategy can be useful to limit
losses. It’s used by large institutions who buy large blocks of options.

Even the individual investor can benefit. By using options, you would cost-effectively be
able to restrict your downside while enjoying the full upside, as in the example below.

Let’s say you buy 100 shares at $30, hoping they will go up soon. To hedge, you buy a put
option at $1 a share, paying a total of $31 per share. The contract guarantees a selling price
of $25 over the course of next 3 months. 2 hypothetical situations could occur during this
period.

The stock price goes down. You limit your losses if the stock price drops to $15. Instead
of losing $15 per share, you lose $6 (($30 +$1) – $25).