I will use Apple trading at $561. If we buy the August $540 strike price calls, it will cost us about $61.40. For a price of $6,140, we can effectively gain exposure to Apple for about 12% of the cost of buying the stock. We won't get a dividend directly when buying options, but dividend payments are calculated into the pricing of options for the most part. Since Apple is trading for $561, it means the cost in time premium is about $20 per share. Even if Apple does move up as hoped, we may not realize any gain with this trade. So let's add another leg to the trade. We can also sell the $600 strike price option. This hedges the long $540 call. As of this writing, we can sell the August $600 for about $34.60 per share or $3,460 per contract. By selling this call option and creating what is known as a spread trade, we limit our profit potential; however, we also lower our risk in price per share as well as cost in time. Our total cost for the spread will be about $2,680. This is known as a bull call spread, or "bull debit spread." The "cost" of the spread beyond the upfront price paid is the loss of profit if Apple moves above $600, so we know if Apple trades at $600 or more, we maximize our gains. Let's take a look and see how much that will be. The upfront cost is $2,680, but the value of the August $540 strike call will be worth $6,000 ($600-$540). This would be more than a double and the best case one can hope for. To at least break even, Apple will need to trade at or above $567, which is about $6 more than at the time of this writing. At a price of $540 and lower, the total $2,680 is fully lost. This sounds extreme to watch the entire premium lost, but keep in mind the buyer of the stock at $561 loses $2,100 of their investment at $540 and at an Apple price of $534.20, an Apple stock buyer loses the same amount ($2,680) as the option investor does. If Apple's price falls below $534.20, the stock buyer faces even larger losses compared with the option buyer.
Let's look at another example with Google ( GOOG), only this time, we will sell put options instead of buying call options. Remember a put option gives the buyer the right to sell a stock instead of buying it. Puts are the mirror image of calls in this regard. To stay consistent, we will continue with our bullish outlook, but here we will trade what is known as a bull put spread, or "bull credit spread." We will let time decay work in our favor. Credit spreads are my favorite way to trade option spreads. Google is currently trading for about $594. If you want to buy 100 shares, it will cost a total of about $5,940 (plus transaction costs). If we sell the $600 September strike put option, we can receive about $41.50 per share, or about $4,150 per contract. This would leave about $558.50 in total risk if Google moves to zero. Because the option is in the money, the amount of capital needed in margin would be near half the amount of risk. On the other hand, if we buy another strike, for example a $560 put for $24.50 or $2,450 total, we will greatly limit our risk compared to a full directional position. Unlike the Apple example, with Google we receive $1,700. The total amount at risk is $2,300 compared with about $59,500 if the stock is bought. Also unlike Apple, the total profit potential is lower relative to the amount at risk. Another important difference is Google does not need to move in price to profit. If Google ends in September at the same price it is today ($594), the trade makes a total profit of $1,100 ($1,700 premium gained less the $6 per share difference of the put option sold for $600 and the current price of $594). Google only needs to move up $6 for this type of trade to maximize the profit potential of $1,700. This presents two different methods of using options to mitigate risk and to fully "dial in the risk/reward" with stocks. Another advantage of both strategies is that volatility is lower with options spreads compared with straight stock exposure. This can be a real benefit when trying to get sleep during earnings season and other announcements.