I will be sharing with you one of the steps of my simple 4-step formula* for achieving success in investment and trading.
This step is about LEVERAGE, i.e. how you can accelerate your return from the stock market investment, and how to make your money work harder for you.
From the survey conducted during Invest Fair Malaysia 2012, the percentage of investors in Malaysia who know what CFD is only 7% and even less know about Option (only 3%). This is naturally so because CFD and Option are not yet developed in the Malaysian stock market or rather our market volume has not been able to support the development of these instruments.
But for those who got to know of these instruments and how to use them correctly, it helps them to venture into the international stock market where much more profit opportunities for their investment are available at a much faster pace.
What is Option?
By definition, an Option is a contract that gives the Buyer the right, but not the obligation to buy or sell a stock at a specified price on or before a specified price on or before a specified expiry date. There are 2 types of Option Contract – Call Option and Put Option.
A Call Option for Stocks gives the Buyer of the contract, the Right but not the obligation to Buy the Stock at a Specific price on or before an Expiry Date by paying a small premium now (typically 2-10% of the stock price).
A simple analogy to Buying a Call Option — think about buying property. When we buy a property we will normally pay a “booking fee,” which is normally about 10% of the property price. That “booking agreement” gives us the right to purchase the property at the agreed price at a future date (usually within 3 months to get the loan approval).
However as a buyer, we are not obligated to buy the property (in which case we will lose the booking fee), but the seller has the obligation to sell if we decide to buy it. It is also possible for us to transfer the “right” to another person, at a higher price, should the value of the property goes up before the agreed date.
A Put Option for Stocks gives the Buyer Of the contract, the Right but the obligation to Sell the Stock at a Specific price on or before an Expiry date by paying a small premium now (typically 2-10% of the stock price).
Put Option can be used as insurance for your Stocks, e.g. if you buy 100 units of Starbucks stocks @$60 but worried the market will crash anytime this month. Then. you can buy 1 contract of Starbucks Put Option which allows you to Sell 100 units of Starbucks stocks at $60 within 1-2 months expiry by paying a small premium now.
Option has all the advantages mentioned above for CFD except the dividend part, which the Option holders are not entitled to any dividend, Despite that Option is actually a much more powerful instrument of the following features and advantages:
- Options is one of the most and versatile financial instrument as it can be constructed to meet many trading objectives, protection, or hedging.
- Ability to make money in any market direction (uptrend. downtrend and even sideways) means more opportunity to trade and meet your financial goals faster.
- Higher probability of winning as you can make money in more than 1 direction concurrently (eg. Win as long as a stock stays above a certain price or below a certain price).
- As option buyer, your risk is only limited to the premium pad in a worse case scenario (usually 2-10% of stock price).
- A trade can cost as low as $20 but it’s better to start with a capital of about $2000
- Can be used as insurance.
- Creative use of 2 more Options contracts can lead to many powerful strategies to take advantage of different market trends and protection equipment.
Key differences between CFD and Option
Here are some key points that an investor or trader should know when deciding to start using CFD or Option :
- CFD is useful for investment and single directional trading (i.e. stocks on a clear uptrend or downtrend) and you can get dividends if you are a buyer.
- Option can also be used for Non-Directional trading, where you can win concurrently in more than 1 direction including sideways.
- Option, whilst more powerful, presents a steeper learning curve as you have to learn how to choose the right contract with different exercise prices and expiry date, and how to use them in correct combinations to achieve your trading objectives. Hence for those who are new to the stock market, we would recommend them to start with CFD as it is easier to comprehend and then proceed to learn options.
Whether you are a short term trader, mid-term trader, or a long term “buy and hold” investor, Options gives you the leverage to achieve your profit target faster and the ability to diversify with your capital while protecting your investment much more effectively. It is definitely worth learning if long term success and consistent income stream from the stock market is your goal.
*For the first 3 steps of my S-T-P-M formula, you can email a request to [email protected]
Written by: Kathlyn Toh, Professional Investor and Trader specializing in the U.S. and global equities market. She is also the Director and Chief Trainer of Beyond Insights Sdn. Bhd.