Adventurous investors don’t just buy stocks—they like to guess which direction the market is heading while still trying to cover their bets.
One way to accomplish this is to buy options, which are also known as a type of derivative. A call option is when you think the price of a stock is going to go up, while a put option is used when you think the price will be going down. With a compound option, the investor is able to “ride” a stock (extend the life) without investing as much money as would be required to buy the stock outright at the current time. Compound options are not risk-free, and they also involve paying a “back fee.”
Here’s how it works:
Charlie is feeling bullish about the current market and, in particular, has been following Optional Compound Inc. So he buys a call option to purchase 200 shares at $50 a share...not today, but six months from now. And he's buying the call option from a seller of that option...kind of like an option to purchase an option. (This is where the compound name comes in). Charlie pays the seller $2,000 for that call option.
So six months roll by, and Charlie decides to exercise the call on the option. In addition to paying for the stock, he has to pay the premium on the second option, buying the 200 shares at $50 per share. This is the back fee; Charlie has to pay $7,800.
It’s best to consult a professional before trying this at home, but compound options can be very useful...if you don’t mind paying a back fee.
Related or Semi-related Video
Finance: What Is a Call Option?25 Views
finance a la shmoop. what is a call option? option? option, where are you? okay
yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]
is the right to call or buy a security. the concept is easy the math is hard.
you think Coca Cola's poised for a breakout as they go into the new low
calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]
call option for $1. well that call option buys you the right
to then buy coke stock at 55 bucks a share anytime you want in the next
hundred and 20 days. so let's say Coke announces its new sugarless drink flavor
zero it's two weeks later and the stock skyrockets to fifty eight dollars a
share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]
so you buy the stock and you're all in now for fifty five dollars plus one or
fifty six bucks a share and your total value is now fifty eight bucks. well you
could turn around today and sell the bundle that moment, and you'll have
turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]
stock not skyrocketed so quickly well you would have lost everything. still you
lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]
options. as for Coke flavor zero turned out to be nothing more than canned water.
Up Next
What is a put option? A put option is a type of contract that lets the investor sell shares of a stock at a certain price and within a window of ti...