35 lines
2.3 KiB
Plaintext
35 lines
2.3 KiB
Plaintext
168 • The Intelligent Option Investor
|
||
1. As shown and mentioned earlier, when using an option, payment
|
||
on the principal amount of $65 in this case is conditional and com-
|
||
pletely discretionary. For an option, the interest payment is made
|
||
up front and is a sunk cost.
|
||
2. Because repayment is discretionary in the case of an option, you
|
||
do not have any financial risk over and above the prepayment of
|
||
interest in the form of an option premium. Repayment of a con-
|
||
ventional loan is mandatory, so you have a large financial risk if
|
||
you cannot repay the principal at maturity in this case.
|
||
Regarding the first difference, not only is the loan conditional
|
||
and discretionary, the loan also has value and can be transferred to
|
||
another for a profit. What I mean is this: if the stock rises quickly, the
|
||
value of that option in the open market will increase, and rather than
|
||
holding the “loan” to maturity, you can simply sell it with your profits
|
||
offsetting the original cost of the prepaid interest plus giving you a
|
||
nice profit.
|
||
Regarding the second difference, consider this: if you are using bor -
|
||
rowed money to invest and your stock drops heavily, the broker will make
|
||
a margin call (i.e., ask you to deposit more capital into the account), and
|
||
if you cannot make the margin call, the broker will liquidate the position
|
||
(most brokers shoot first and ask questions later, simply closing out the
|
||
position and selling other assets to cover the loss at the first sign margin
|
||
requirements will not be met). If this happens, you can be 100 percent
|
||
correct on your valuation long term but still fail to benefit economically
|
||
because the position has been forcibly closed. In the case of options, the
|
||
underlying stock can lose 20 percent in a single day, and the owner of a
|
||
call option will never receive a margin call. The flip side of this benefit
|
||
is that although you are not at risk of losing a position to a margin call,
|
||
option ownership does not guarantee that you will receive an economic
|
||
reward either.
|
||
For example, if the option mentioned in the preceding example ex-
|
||
pires in two years when the stock is trading at $64.99 and the stock has paid
|
||
$2.10 in dividends over the previous two years, the option holder ends up
|
||
with neither the stock nor the dividend check. |