Without a doubt, options offer great leverage, as well as flexibility.
At times, they can offer us income almost out of thin air. They offer us the ability to make money if the price of the underlying instrument doesn’t even move.
But it gets even better than that.
Let’s say I wanted to buy 100 shares of Disney (DIS) in early December 2017, as the stock traded at $106 a share. It would cost me $10,600.
Not many of us have that kind of money just sitting around.
So, we can opt to pick up an option contract, which allow us to control 100 shares without ever taking ownership of those shares.
Let’s also I chose to buy the DIS February 16, 2018 105 calls with a current price of $4.75 (or $475 - $4.75 x 100 shares in a contract). If DIS now moves up $5, I made a whopping 5% on $10,600 risked. However, with that same $1 move in the stock, I had the opportunity to earn 60% on $475 risked.
We came to that conclusion by relying on Options Greeks, which help me figure out how much money I can make based on set criteria characterized by five Greek symbols. For example –
- Delta tells us how much an option will change every time our stock moves up $1. For example, with the DIS February 16, 2018 105 calls, I can see that for every $1 move higher in the underlying DIS stock, I earn $0.5696 at the moment.
- Gamma tells us how much the delta can increase every time the stock moves higher. For every $1 move higher in the DIS stock, gamma tells us how much more the delta will increase by. For example, if DIS moves to $107.00, delta will increase in value by 0.0370. It may not seem like much, but it adds up.
- Theta is time decay. It will tell us how much our option price loses every day. For every day you hold an option it will lose value. That’s just how it is. Nothing in life is without risk. Theta tells us that our call option will lose just over three cents at the moment. This will speed up and get bigger as you near expiration.
- Vega tells us how much an option price will change on moves in volatility.
- Rho tells us how much options will change with interest rates. No one really pays much attention to rho any more. The rate of change here doesn't move much.
In a nutshell, that’s how we can calculate potential rewards. And as you can see with our DIS examples, the rewards can be quite big.
Always account for probabilities each time you open a new options trade.