That method is buying and selling stock options. How to
trade stock options would best be explained using the following example.
Lets say a person who thought that a stock selling in the
market at 50 would decline to possibly 30, that person could buy a Put stock
option. Not, however, that in buying a stock options, one should have some idea
to what extent the stock might move.
In inquiring what a Put stock option would cost, the person
might receive a nominal quote of, say, $350 for a Put at the market for 90
days. Most options are negotiated "at the market," which means at
"the current market," when the option can be obtained by the option-dealer.
Suppose that the stock is selling at 50 and the quoted price
of $350 is satisfactory to you. You enter your order: "Buy a 90-day Put on
100 XYZ [the name of the stock] for $350." If you are trading through your
stock-exchange broker, the broker will give your order to an option-dealer who
will contact one of their clients who sells options on that stock and will
attempt to buy the option for you.
When, after this contact or several others, the dealer has
obtained the Put option for you, the dealer reports to the stock-exchange
broker who gave him the order, and the broker in turn reports to the customer:
"Bought Put 100 XYZ at 50 expires December 30 for $350." Let us say
that the person who bought the Put option, expecting a decline in the stock,
was wrong, and that the stock, instead of going to 30 (as expected), advanced
to 70 and was selling when his option expired. The person would have lost the
$350 that they paid for the Put option.
Bear in mind that the limit of the person's loss was the
cost of the Put option, or $350, no matter how high the stock rose and no
matter how wrong the person was, and that the person would draw on the equity
in the account to that extent only. Suppose, on the other hand, the person had
sold the stock short in the market. The loss would have been 20 points and
still no knowledge as to the possible extent of loss until the person covered
the short sale. But in the purchase of the Put option the account would read:
Bought Put on XYZ at 50 for 90 days: Loss $350
Remember, too, that no trade has been made in the stock, so
no stock-exchange commission has been paid. A regular stock-exchange commission
is charged by your broker only if a transfer of stock is made in connection
with the option.
On the other hand, suppose the person's judgment was correct
and the stock declined to 30. If the person had instructed the stockbroker to
buy 100 shares at 30 and exercise the Put option, the account would look like
this:
Sold 100 shares at 50 (through exercise of Put) $5,000
Total Receipts $5,000
Bought 100 shares in market at 30 3,000
Bought Put at 50
Cost 350
Total Cost 3,350
Profit on trade $1,650
The profit then would be almost 500 percent of the cost of
the Put contract. The profit is the difference between the cost of the stock
plus the cost of the Put option and the proceeds of the Put that was exercised.
In all of these examples showing the use of options, the
commission cost has been ignored.
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