When does it make sense to buy Options?

There are only two reasons that I consider looking at options:

  1. Income Generation
  2. Purchasing stocks (that I already want) at a lower price than the current market price

Basically, either for additional income or for bargain shopping. And, as it turns out, neither of these reasons are good enough when the market is clearly bullish.

Income Generation

In a bull market (of the kind that we are currently in – summer of 2011), it does not make sense to use options for income generation. The reason is simple. You will get much higher returns simply finding (somewhat beaten up) stocks and watching them appreciate (as they will in a normal bull market). The returns on a good stock in a bull market trump any gains that options can possibly provide. In addition, you have the luxury of owning the underlying asset at all times.

Purchasing stocks (that I already want) at a lower price than the current market price

Again, while writing PUTs is a good way to purchase stocks at a lower price (than the current market price), it also suffers from two disadvantages in a bull market

  1. You may not get the underlying stock – since the price may stay steady or move up – never reaching the strike price
  2. You WILL tie up the money in the written PUT – since you are obligated to buy the stock if the price reaches the strike price. This means that your account will need to have the additional cash balance to make the purchase for the entire duration of the option (till expiration). This ties up the money that could be well used to purchase other rising stocks in the bull market.

Summary

In a market that is flat or declining (bearish), options provide a way to generate income without buying risky stocks (risky because the market sentiment is bearish and/or the market is staying flat). In such a market condition, it may make sense to buy/write options to generate income – or even to buy your favorite stocks at bargain prices. However, in a clearly bullish market (such as the one we currently have in the summer of 2011), none of these reasons are strong enough to outweigh the basic bull ride that a half-decent stock can give you.

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