Financial Markets Book Financial Markets For The Rest Of Us
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
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by Robert Hashemian

Page 283

sense you can think of this as an insurance. By paying the $400 total premium you have locked in the price you would pay for up to 200 shares of Ford for the next 20 days. Now suppose the stock does indeed begin to move up from its current $50 to $60 within this 20-day period. You are probably beginning to see the plan. Sure you would say, just borrow the $10,000 and exercise the contracts to buy 200 shares of Ford for the locked-in price of $50 (the strike price). Then immediately turn around and sell the 200 shares in the market for $60 per share for the total of $12,000. Pay off the $10,000 loan, and pocket the $2,000. So from $400 initial investment in the call options, your profit is

$2,000-$400 = $1,600

which works out to a 400% return on your investment. Compare that to the 20% return if you had just bought and sold the stock. Not bad, huh?

It even gets better. Turns out that just like futures most options are never exercised, instead they are settled or offset. Going back to our example, when you buy the 2 FAJ contracts, you are long 2 contracts. When the stock hits $60, the FAJ options also rise in price perhaps to $10. At this point all you have to do is to go short 2 contracts (meaning sell your 2 contracts) for the total of

2 contracts x 100 shares per contract x $10 = $2,000

Again you are back at your $1,600 profit but this time you didn't have to exercise your contracts by buying the stock and then selling, saving time and commission. You would be hard pressed to find any options getting exercised. Just about all of them are settled prior to their expiration.

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Bonds Futures Stocks Options
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