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David Bickings, Optionetics.com
August 8, 2001

Just like stocks and bonds, options are a unique investment vehicle.  Each trading instrument has distinct advantages and disadvantages that must be weighed before investors can decide which one best suits them.  Since options are such a complex instrument, it’s vital to understand how you can minimize the effects of their disadvantages to foster better investment results.  

Since, as a society, we tend to seek instant gratification, let’s start with the advantages of using options over the more traditional equity investments.  The first thing you notice when pulling up an option’s symbol on the web is the option’s price.  Options always cost significantly less than the market price of the underlying security, which enables options buyers to control an asset that otherwise would have been out of reach.  This is called leverage and is a great advantage to the option buyer.  

Each equity option’s contract represents 100 shares of the underlying security.  You can either trade the contract when it’s value appreciates, let it expire when it’s value declines, or exercise it and buy the stock at the exercise price when it has real value.  For instance, let’s assume you have $5,000.00 to invest and like the prospects for Abercrombie and Fitch (ANF), the casual clothing retailer.  You could buy a round lot of 100 shares of the stock (using the market’s closing price on 8/7/01 of $37.01) for a total of $3,701.00 plus commissions. I’m sure many of us do not have that kind of cash in our accounts just waiting to be invested.  You could chose to buy a smaller number of shares, but then commissions would make up a larger part of your total investment cost.  In addition, if you bought 100 shares, you’d be breaking one of the cardinal rules of investing: putting all your eggs in one basket.  

Since your belief is that ANF will make a sizable move by November of this year, your alternative is to buy an options contract expiring in November with a strike price at- or near-the-money.  The November 2001 ANF $35 call closed (as of today, 8-7-01) at an offering price of $6.20.  This is known as the premium.  Since you can usually split the bid and offering prices down the middle, you can probably get it for less, but for simplicity’s sake, let’s assume you buy at the offer.  Since that contract represents 100 shares of ANF, you’ll need to multiply the $6.20 by 100 for a total cost of $620 plus commissions.  For an investment of only 16.7% of the cost to buy the stock, you can still participate in the price movement and profit handsomely if you are right.  

The second distinct advantage of options is that your percent returns can be much higher than if you own the equity, and come a lot faster in many cases.  Here’s what will happen if you are right about ANF if the stock moves as you anticipated and closes on the third Friday of November at $45 per share.  If you own the stock, your percent return, excluding commissions, will be 21.59%.  At a closing price of $45, the November 35 call will be worth at least $10.00.  In this case your percent return was much higher at 61.29%!  You made a higher percentage return, paid less for the opportunity to do so, and could have put the remainder of the money to use in a fixed account, or diversified your options holdings and bought a few other options on other stocks you like and believe will appreciate in the next several months.

The third and possibly most important advantage options have over stocks is that they offer the chance for dramatic returns with limited risk in most cases.   When you buy options, your risk is always limited to the amount you paid for the options.  There’s no further loss possible.  In keeping with the example above, suppose the November 35 call expired worthless because ANF reported bad earnings and dropped to $12 per share.  The most you could lose would be the cost, or $620.  If you bought the stock at $37.01, it would have resulted in a $25 per share loss!  Risk management—keeping losses to a minimum when they inevitably occur—is the biggest difference between a successful trader and a broke trader.

Now, let’s look at the two major disadvantages of an options contract.  First and foremost, they have a finite life.  In the example above, the November call expires on the third Friday of the month.  Regardless of whether ANF shoots skyward on the Monday following the third Friday in November to $500 per share, your option has expired and is therefore worthless if it wasn’t exercised or traded away on or before the expiration day.  Exercise only takes place when an option is in-the-money, meaning that the strike price of the option plus the premium is less than the market price of the security.  If you want to buy ANF and hold it for 10 years, options are not for you unless you intend to use them to buy the stock at a discount to the market price and actually take possession of the stock itself.

The second major disadvantage of the options contract is that it can turn against you and cause rapid losses just as it can give you rapid gains. This is known as volatility.  The key here is that those losses are limited and controlled and are predetermined so that you know up front just how much you can possibly lose before getting into your position.  However, it would be unjust to not warn you of the way the leverage can work against you just as it can work in your favor.  A few bad days in a row will not likely cause significant losses in a well-established company’s stock.  But the options on a well-established stock can be reduced by 50% or more in the span of a few days if the stock spirals downward.  Volatility is a double-edged sword because it works for and against you depending on the underlying stock’s movement.  It is therefore recommended that you select call options on quality stocks with a fairly predictable earnings history that are likely to appreciate over a three to nine month period, or at worst decline mildly.  You may then be able to salvage at least some of your premium and sell out a loss rather than letting the option expire worthless.  

Good luck and great trading!


David Bickings
Staff Writer & Options Stategist
Optionetics.com ~ Your Options Education Site
dbickings@optionetics.com

 

 

  

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