A friend of mine recently asked me the following question – What exactly are options – and why would anyone trade options as opposed to stocks. I will try and explain what exactly options are through the following points of why anyone would trade options. There are at least five reasons why options can prove to be better investments than stocks (and several reasons why they would not)
- Larger profits for smaller up-front investments (leverage)
- Lower Risk (Less Money at Risk)
- Income Generation – by using spreads
- Getting a better deal on stocks you would like to own anyway
- Stock Shorting ability without actually shorting stocks
Larger Profits for smaller Investments (Leveraging)
Imagine you are bullish on MSFT (currently trading around $25) – and buy a 100 shares. After 12 months, MSFT hits $35. Your profit was $1000 – with a 40% return for the year. Now imagine that instead of buying the stock, you bought a call option. The option costs $2 a share (so you spend $200). The option is for the stock price to hit $35 within 12 months (trading terminology would say that the strike price is $35). As soon as your strike price is reached, you may exercise your option – and purchase MSFT at $25! When the whole world has to pay $35, you only need to pay $25 – because you had the foresight to bet on it 12 months in advance. Now – you have just made $1000 again (same dollar amount as in the stock scenario) – but with an investment of only $200! That’s a return of 500% – clearly putting your 40% return to shame.
What could go wrong?
- Well, for one, if the price never reaches $35, you have lost your $200 – your options expire worthless.
- Imagine that the stock does go up, all the way from $25 to $34. There’s no advantage for you, since your bet is that it reaches $35. If you had just owned the stock (bought at $25), you would have been up $9 a share! So – you lose out both ways (your option premium of $200 is down the drain as is the chance of a $9 appreciation on the underlying stock).
So, not only do you have to get the price right (that is – your bet that it reaches $35 has to be correct), but you have to also get the time right. If the stock reaches $35 one day after the 12 month period is over, it still doesn’t help you. It needs to reach the strike price within the allotted time period (before expiration).
Lower Risk (Less Money at Risk)
This should be obvious from the previous example where your up-front money was $200 (as opposed to buying 100 shares which would have cost you $2500). Worst case, if MSFT really tanked and hit $10 share, you would still not be affected. Your risk was limited to the $200.
Instead of purchasing options, you can actually be the writer of options. For every call option that is bought, someone is writing the call option (the writer of the call option is expecting the stock to decline as opposed to the buyer – who is bullish on the stock). The writer of the options gets paid immediately. This can be considered income generation. For an example of income generation, see the next topic (Getting a better deal on stocks you would like to own anyway)
Getting a better deal on stocks you would like to own anyway
Writing puts is a great way to get stocks you want anyway at a lower price (if they do not make the strike price, you still get the income from writing the put). Just as a call writer is bearish on a stock, a put writer is bullish on a stock. When you write a put, you get paid right away (the amount that the put seller is paying for her premium). This income can be pocketed right away. The only downside to writing a put is if the stock clearly falls below a certain value – (the strike price – the premium), then you are obligated to buy the stock at the higher price (the strike price).
As an example, suppose you are bullish on MSFT and think it will not fall below its current price ($25). You write a 3 month put which has a premium of $2 (which means you get paid $2 right away by anyone interested in your put option). Now, the only promise you have made is that if the stock falls below $25 in the next 3 months, you will buy it – for $25 (Keep in mind, that you have already made $2 on this stock – so even if you were to buy it AT $25, you would still have made money). All the way down to $23, you are still in the money (for e.g. – if the stock is at $24 – and you are forced to buy it at $25, remember that you have effectively paid $23 for it, so you are still up $1).
It is only when the stock falls to below the $23 mark (the strike price – the premium), that you start losing money. If you pick fairly steady/stable stocks (such as MSFT), chances of them falling 8% ($2) in 3 months are low – so you should feel fairly secured Say you DO have to buy the stock (means that the stock was below $25 at the time of expiration), it is still a great way to purchase the stock at a price that you can live with. In other words, you would not MIND buying MSFT at $23 (which is what your effective price would be if the stock ended at $25), writing a put gives you just that ability.
So – what could go wrong?
Again, if the stock completely tanks (say goes to $10), you are still obligated to buy it at $25. Now, you are seriously out of the money. It only makes sense to write puts on fairly stable stocks which are well priced (in that, they are most likely not going to undergo huge gains or huge losses).
Stock Shorting ability without actually shorting stocks
If you are bearish on a stock and decide to short it, you have to keep three things in mind:
- You need to have the cash for covering your short in your account upfront. In other words, you cannot short a stock (sell it) without having the money to buy it back. When you sell it (short it), you are effectively borrowing the shares from a brokerage house.
- You need to pay interest (to the brokerage house) on the shares you have borrowed.
- If the underlying stock paid dividends, you are liable to pay the dividends to the brokerage house.
A put option would let you effectively short a stock without any of the above restrictions.
Owning the underlying stock and purchasing an option on it
You may be wondering that if someone is clearly bullish on a stock, why is she restricted to either trading options or the underlying stock? Can’t she trade both? The answer is yes – there is nothing preventing you from owning the underlying stock and buying an option on the security as well. This is called a covered call (in the case of writing a call option along with owning the underlying stock). There are many reasons why you might want to do this. Here is a good article describing why investors deal with covered calls.
There are at least five reasons where options make sense over stocks. There are enough reasons for going the other way – purchasing stocks over options. One of the more common ones is, if you are bullish but over a long term, then it may be better to purchase the underlying stock. Also, if you are clearly bullish in the short-term – and have the upfront money to buy the stock (i.e. are not interested in leveraging a small amount of upfront money), then you may be better off purchasing the stock outright (click here to read more about this scenario).