Copyright 2006 Billy Williams
In the investing world, trillions of dollars worth of shares are bought and sold each day on the major exchanges all over the world. On any given day, traders and investors can take part in the purest form of capitalism by putting their money at risk by buying into any of the major global corporations across the planet in the pursuit of profit. Yet, there is another way of speculating, trading options, which can be far superior to just trading the shares of a given company.
An option is a derivative on an underlying security that gives the right, but not necessarily the obligation, to buy the underlying security at a given set price. They come with different strike prices, expiration dates, and allow tremendous leverage as each option controls up to 100 shares of stock in a particular company. These advantages make options a far superior trading instrument than just trading stocks.
One advantage is leverage. Leverage is the ability to use a small amount of capital to control a huge asset. Like in real estate, where a small down payment allows a prospective buyer to control a huge piece of property, options allow the trader to control up to 100 shares of stock for with just a tiny bit of capital or, in this case, it is called the option’s “premium” which is the actual cost of the option.
Let’s look at an example of how options are superior to stocks in when using leverage. If you notice that ABC stock is set to rally higher and is trading at $50 a share and you then buy 100 shares of stock for a total of $5,000. A few weeks later, ABC stock has rallied to $60 a share and you sell all your shares you will have profited $1000 or a 20% return. Not too bad.
But a friend of yours sees the same setup in ABC stock and decides instead to buy an option with a $50 strike price which is priced a $2 premium for a total cost of $200 ($2 X 100 shares = $200). ABC stock rallies to $60 and your friend sells his $50 strike option for $1200 which is a 500% return! That’s the power of leverage when trading options.
Another advantage is that a trader can generate income by using credit spreads with options. If you see that ABC stock is in a trading range and is staying above support at say around $50 a share you can create a credit spread by creating what is called a Bull Put Spread. You sell the current month’s $50 put option and pocket the premium you received and then purchase the current month’s $45 put option for insurance in case the stock plummets unexpectedly. Then sit back and let the options reach their expiration date and you collect the difference between the premium received for selling the $50 put option and the cost of purchasing the $45 put option.
ABC stock can go up or stay around $50 and the position would make money. It could even decline below $50 equal to the cost of the premium that was received and the position would break even! The only time the position could lose money is if it declined below this breakeven point. Many option traders specialize in these types of option spreads only and generate often generate steady returns of 10% to 90% per position!
A third advantage is options also give you the ability to short stocks without the restrictions of short-selling stocks. When you short a stock in the anticipation that it will go down in price you not only have a larger cash outlay versus buying put options but you also have to pay interest on the stock you borrowed to short plus you have to pay the dividends back that the stock might pay during the time you hold it. With put options, you avoid all that plus you can make faster returns and much sooner since the stocks will usually fall twice as fast as they rise.
Additionally, if a stock is rumored to miss its earning projections you can make a lot of money quick by playing negative earning releases in the right market environment. The reason is that stocks can often gap down by 50% or more on bad news. That translates into a hug profit to a smart option trader without tying up a lot of capital.
That also brings up the most important advantage is that the most you risk is the actual premium you paid for the option itself. If a stock gaps up or down on news and you’re on the other side of that trade you only risk a small amount of you capital where if you had bought the stock you could lose half your position overnight! Early in 2006, Google reported strong earnings but not as great as Wall Street had expected and the stock was pummeled. Then a few weeks later, Google’s Chief Financial Officer spoke publicly about a temporary pullback in their future growth and the stock plummeted. If an options trader were long Google call options at that time that trader would have only lost a small portion of his overall trading capital versus someone who had bought the stock itself (Google’s stock had been as high as $475 before these events and then lost almost a 150 points in a couple of weeks as a result).
The advantages written here are only a few compared to the dozens that options afford traders who are disciplined enough to learn them. Stocks have been likened like playing the game checkers where options are compared to the game chess because of the tremendous opportunity and flexibility that they can give traders and investors. Stock and option traders that take the time to learn and apply a few simple strategies offered by options can better assess risks in the markets and potentially put themselves into positions to profit handsomely.