Know Your Options
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April 24, 2002
Options are filled with opportunity. There are several basic reasons to trade them and this week we’ll look at those reasons, and learn how and why you may want to trade options.
Most of us use options to profit from the accurate prediction of a stock’s movement. In doing so, you can make money from the appreciation of a stock without owning the stock itself. The purchase of a call gives you the right to buy 100 shares of a stock at a specific price—known as the strike price—on or before a predetermined date. When the price of a stock rises above the strike price of a call option, the call becomes valuable because it allows the owner to buy the stock at a price less than the current market price. As the stock’s price climbs, the call option’s price will climb too, but usually at a much faster percentage rate.
Another frequently cited reason to trade options is their ability to leverage limited capital.
If you like the prospects of XYZ company over the next six months, you may buy a call option seven or eight months out. That way, even if you were wrong about the price action within that time frame, you might still salvage some of your investment because there’s still some time premium in the option. Time premium has its fastest decay in the last month before expiration.
Here’s an example with two investors, both projecting the same 20% move in the stock. One buys the stock, the other buys a call option. Let’s see how they do when the stock moves upward and when it plummets. Tom, with XYZ trading at $55.17, projects a 20% gain between now and October and purchases 100 shares of the stock for $5,517. Mike, a savvy options trader, sees the same gain and instead buys a $55 call option expiring in December. That could cost about $5.00 to $7.00, depending on the volatility for the stock. He must multiply the premium by 100 since the call options give him control of 100 shares. His cost would then be between $500 and $700 rather than the $5,517 Tom has tied up.
And here’s where the leverage works. Imagine that they were right and XYZ closes at $67.75 on the last trading day in October. The stock has a nice gain of 22.8%. Not bad, right? Pat yourself on the back, Tom. No one would complain about a 22% gain in 6 months. Tom cashes out and takes his $1,258 gain and looks for other opportunities. Mike’s call option is worth at least $12.75 with the stock at $67.75. Let’s assume Mike’s call option was priced at $7.00. Mike also decides enough is enough and cashes out. Mike walks away with a dollar gain of $575 and a percentage gain of 82.14%! Very good, indeed.
Which investor would you rather be? Tom made more money, but took on a lot more risk, as you’ll see in a minute. Tom still made money but had an excellent percentage gain and took on far less risk. Let’s assume both guys were wrong. XYZ drops to $43.50 per share by October. Tom owns 100 shares and they’re now worth $4,350. That’s a loss of $2,425. Tom still owns the stock and can hold it, hoping it will someday rise to the point where he can break even. It could take a long time for that to happen, if at all, and his money is tied up until then. Mike’s call contract would now be close to worthless. Let’s say it’s still worth 90 cents because it still has some time premium left. Mike’s dollar loss would be $610 and his percentage loss would be 87.14%. His maximum risk was only the $700 he paid for the call. Tom lost over two grand and still could lose more unless he gets out and moves on, which is extremely difficult for many investors to accept. Again, which investor would you rather be?
Some investors use options to diversify their holdings. Since there is a lower dollar output for each contract, an investor might be able to buy calls on eight to ten stocks with a $5,000 investment, rather than 100 shares of only two or three stocks. This cuts exposure to a small number of investments and helps smooth out the inevitable ups and downs.
Hedging stock positions is another reason to utilize options in your portfolio. They can act like insurance against loss. Imagine that our stock investor, Tom, bought a $50 put on XYZ for $3.50, when he bought the stock. His loss would have been capped at $867, not including commissions. When XYZ dropped below $50, Tom could have exercised the put and sold the stock at $50 regardless of the market price of the stock. His loss on the stock would be $5.17 and his cost for the put was $3.50 for a total of $8.67. For an extra $350 when the trade was made, Tom could have saved $1,558.
Lastly, many people use options to earn income from the sale of options that they think will be worthless at expiration. As in the example above, Tom paid someone $350 for the put option. Had the stock moved upward as Tom originally predicted, the seller of the put would have banked $350 just for assuming the risk. In the case where the stock dropped, however, the seller had to buy from Tom 100 shares of XYZ at $50, even when it was trading on the open market at $43.50. This would have resulted in a loss of $6.50 from the stock price drop minus the $3.50 earned in premium for a total loss of $3.00 or $300.
To earn income from premiums you must, I repeat, must already own the stock or buy another option to hedge yourself in the event you are wrong. Failure to do so is known as selling a naked option and can result in catastrophic losses. Do your homework! If you’re interested in selling options for income, be extremely careful in your selection process and use options where there is little time left until expiration, reducing the amount of time you are at risk. You’ll get less each time you sell, but risk will be reduced exponentially. Be prepared to lay down large amounts of capital if you want to sell naked options, because margin requirements will be very large.
Good luck and great trading!
David Bickings
Staff Writer & Trading Strategist
Optionetics.com ~ Your Options Education Website
dbickings@optionetics.com
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