At WealthMastery.sg, our writers do not just churn out articles. We see ourselves on a mission. We take it upon ourselves to educate you, enlighten you and enriching you on matters regarding your personal finances as well as your investments.
As some of you might already know… we take this mission very seriously.
Hence, we are going to embark on a series of educational articles in a bid to educate the common man on the other more advanced investment tools out there which fund managers use to add that little “oomph” to their portfolio returns.
Introducing Options: The Lamborghinis of the financial world
Just like any financial instruments out there, options are just another vehicle that gets you to your intended (financial) destination.
Why I refer to options as the Lamborghinis of the financial world is purely because of the speed of which it can get you there.
The returns which options can make are incredibly huge and amazingly quick. However as all drivers of fast cars would know… with great speed comes great danger.
BEFORE WE BEGIN…
It’s not the Lamborghini that is dangerous, it’s the driver.
Contrary to popular belief, danger does not come from the fast car itself. A Lamborghini would not explode while it’s parked in your garage.
Danger instead, comes from the man behind the wheel. The most dangerous thing in the car is the driver yourself.
Similar, options are not dangerous when the investor using it knows what he is doing. Warren Buffett may be one of the most risk averse investors out there, but even he uses options to boost his returns.
When the trader does not know what he is doing,
everything he does is dangerous.
So, what exactly are options?
According to Investopedia, an option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security.
Confused? Not to worry. Options are actually present in everyday situations.
Let’s take for example the act of buying a house.
Imagine that you’ve found a beautiful HDB at Lakeside that you love but you don’t have enough money to buy it yet for another three months.
So you talk to the owner about it and he agrees to give you an option to buy the house anytime within the next three months for $300,000.
However, for that option, you would have to pay him $3,000.
In other words, that option is his promise to sell you the house for $300,000.
During the next three months, 2 things might happen:
- The government announces that they have decided to redevelop the area around your property. They are going to build a LRT train station within walking distance of the property. Also, three new shopping malls are going to be built nearby. In addition, they are going to extensively clean up the lake and renovate the park surrounding it, giving your HDB flat a beautiful lake view from your balcony!
As a result, the valuation of your property shoots up to $453,000. However, as you have bought the option, the owner is obligated to sell you the house at $300,000.
Thus at the end of the day, you make a profit of $150,000 by selling the house immediately after purchasing it from the owner.
$453,000 – $300,000 – $3,000 = $150,000
Now, that’s a 5,000% gain from your initial sum of $3,000! Not too bad isn’t it?
- You discovered that the property is going for cheap because a gruesome murder took place in it. The owner is trying very hard to get rid of it and even if you had purchased it, it would be hard for you to sell it off at a profit. Now, the property is worthless and you don’t want to buy it anymore, even at $300,000.
The good news is that you are not obligated to go through with the purchase since you only purchase the option. Of course, you will still lose the $3,000 you’ve paid on the option.
It could have been much worse if you have decided to purchase the flat three months ago. You would have ended up $300,000 poorer with a flat that you cannot get rid of.
Phew, that was a close shave!
Although the above example was regarding housing purchases, options are actually used by many investors for many other forms of asset classes.
There are options available for stocks, commodities, Forex and anything you can think of.
By understanding options, you open another dimension to your investment education.
Who knows, it might even be that additional channel of returns for your investment portfolio!
In the next article, we will talk about how some famous investors use options to increase their returns. Stay tuned!
Image Credits: wonderfulengineering.com