by Andy Chambers

What are the differences between purchasing shares of stock compared to purchasing an option contract? Let’s say that you happen to feel that the stock of IBM is likely to increase in value by around 10% during the next six months. You could buy the stock, wait for the price to increase, and then sell if for a profit. If IBM is trading at $80 a share on the day of your purchase and you decide to buy 100 shares, your investment would be:

100 Shares at $80 a Share = $8,000

If you’re right and the price of the stock increases in value from $80 a share to $88 a share, your investment would be valued at $8,800 and you’d have a profit of $800, or 10%.

However, instead of purchasing 100 shares of stock in IBM, you could have purchased an ‘option contract’. An option contract would give you the right to buy the stock at a specified price, let’s say $80 a share, within a specified period of time, let’s say 6 months. The price that you would pay for the option is called the ‘option premium’. When purchasing an option contract, the option premium is determined by ‘the market’. In other words, traders around the world that are interested in purchasing the same option will have to ‘bid’, or specify a price that they’re willing to pay. The price that other interested parties are willing to pay for an item is referred to as ‘the market’. For this example, let’s use an option premium price of $775. Options on stocks are created by the options exchange and one option contract represents 100 shares of stock.

Let’s compare the purchase of a stock to the purchase of an option on the same stock. Let’s say we had purchased 100 shares of IBM at $80 a share, the cost of doing the trade would be $8,000. If the price of the stock goes to $88 a share, your profit would be 10% or $800. If the price of the stock declines to $70 a share, your profit loss would be $10 a share or $1,000. But, if IBM suddenly goes bankrupt and the price of the stock drops to zero, you’d lose your entire investment of $8,000.

If you were to buy the option based on a price of $775, you’d be purchasing the right to buy 100 shares of stock in IBM at a predetermined price of $80 a share. If you’re right, and the price of the stock increases in value to $88 a share, you have the right to purchase it at $80. Therefore, you have an automatic profit of $8 a share should you decide to exercise your option. However, if you decide to hold your option until the end of the 6-month period and the stock is still trading at $88 a share, your trade would be over and the options exchange would pay you for your profit of $8 a share, or $800.

Now, let’s compare the two trades. First we’ll look at buying 100 shares of the stock:

100 Shares at $80 a Share = $8,000

The Stock goes to $88 a Share = $800 Profit

Next, we’ll look at buying one option contract:

1 Option Contract = $775

The Stock goes to $88 a Share = $800 Profit

If the price of the stock goes up 10% to $88 a share, the profit on each trade is the same.

We need to point out here that if the 10% gain happens within the first few months of the 6-month contract, other traders would be willing to pay more for the option because of the fact that there’s still quite a bit of time left in the contract. If the gain happens quickly, the market value of the option would give you more profit than the $800 we are using in this example. But to keep it simple, we’ll ignore the time value of the option for this example.

What if the price of the stock goes up, but it only goes to $81 a share?

100 Shares at $80 a Share = $8,000

The Stock goes to $81 a Share = $100 Profit

Compare this to buying one option contract:

1 Option Contract = $775

The Stock goes to $81 a Share = $100 Profit

As you can see, the profit is the same. In fact, as long as the price of the stock is equal to or greater than $80 a share, the profit on both trades is exactly the same.

But, what if the price of the stock declines to $70 a share?

100 Shares at $80 a Share = $8,000

The Stock declines to $70 a Share = $1,000 Loss

Compare this to buying one option contract:

1 Option Contract = $775

If the stock were to decline to $70 a share, there would be very little value in the option. The value would depend on what other traders would be willing to pay for it. For this example, let’s assume the value of the option would be zero.

The Stock Declines to $70 a Share = $775 Loss

In this case, if the option has very little or no value, your loss would be limited to the option premium of $775.

Worse yet, what would happen if you purchased the stock and IBM suddenly went into bankruptcy?

100 Shares at $80 a Share = $8,000

IBM Enters Bankruptcy = $8,000 Loss

Compare this to buying one option contract:

1 Option Contract = $775

IBM Enters Bankruptcy = $775 Loss

In this instance, as long as the value of the stock remains above $80 a share, both the stock and the option will have the same amount of profit. However, if the value of the stock slips below $80 a share, the option will lose value faster until it gets to the maximum loss of $775.