In yesterday's blog I gave a brief introduction to what stock options are. I also gave an example of both a winning options play and a losing one, and the result of each scenario. Today I'll touch on some of the reasons people find options such an attractive investment tool.

Options can be bought relatively cheaply when compared to stocks. For example, yesterday I showed you that Google (GOOG) was trading at $288, and a July 2005 call option with the strike price of $290 was selling at a premium of $16.25. This means that if you were expecting Google to make a 20 point jump before the third friday in July, when the option expires, you would have two choices. You could buy the google stock at $288, sell at $308, and make $20 per share minus commissions. Let's say you bought 100 shares of Google at $288, which would be $28,800. You then sold all 100 shares at $308, giving you $30,800. You just made a $2000 profit on a $28,800 investment in about 6 weeks. Roughly 7% return, which isn't bad for 6 weeks.

However, had you bought one contract of $290 call options for July 2005 at $16.25, it would cost you $1,625. You then exercise these options when Google hits $308 and sell immediately, effectively buying for $290 and immediately selling for $308 for an $18/share profit. You've now made $1800 minus $1625 (the premium you paid to buy the options) = $175 profit on a $1625 investment, which is a 10.7% return, in about 6 weeks.

These examples don't factor in commissions of course, in which the options trading the way I laid it out would have had higher commission costs, but not enough to offset the gains. You'll also notice that in the stock example you would need $28,800 in capital to get a 7% return, whereas in the options example you needed only $1625 to make an almost 11% return in the same time period.

Another advantage of the options trade is that your losses are limited to your initial (smaller) investment. If Google were to tank for some reason, the most you could lose would be your $1625 premium in buying the options. However, if you bought the stock at $288, and it fell to $188, you would be sitting on a $100/share loss, or in the case of 100 shares a $10,000 loss.

You don't even have to exercise the options to make money on them. You can trade options almost like stock, which means you can sell the option at a later time without ever buying the stock. If Google jumped to $308, the $290 call option you own would become very valuable, especially if the jump happened long before the expiration date.

I'm painting a very rosy picture of options here, and it's important you know that it's not all winning, if it were everyone would be a millionaire from their options trading. Options do have a severe disadvantage when compared to stocks, and that's time decay, which I will talk about in tomorrow's blog.mortgage calculator