The Benefits of Trading with Options
For anyone who is uncertain about how the stock market will act in the near term – and that describes just about every stockholder – options present tremendous opportunities. They let you leverage your investment capital, give you greater flexibility when making investment decisions, and allow you to tailor your risk to fit your personal comfort level. They can be used to speculate in the market for profit, earn income to enhance your investment returns, protect against a temporary decline in a stock’s value, or to hedge your entire portfolio against market risk.
An option trader can profit in either an up or a down market. When you buy an option, you are hoping that the underlying stock will move in the direction you want. If you’re right, you make a profit. If you’re wrong, you lose money. It really is all a matter of time – the option contract always expires at some point – and of timing. As with all forms of trading, timing is everything. Most of all, it is important to take the time and learn as much as you can about options and option strategies before you trade them.
The Leverage Inherent in Options
Each option contract gives you the right to buy (a call option) or sell (a put option) 100 shares of stock at a specific price (the strike price) by a specific date in time (the expiration date). When you buy an option, you hope that the stock will move in your predicted direction, and quickly enough to make a profit. The cost of the option – the option premium – is far less than the cost of buying 100 shares of stock.
For example, it would cost $6,000 to buy 100 shares of a stock currently worth $60 a share. If the option premium for a call option on this stock is $4, you could buy the option for only $400. That gives you the right to buy 100 shares of the stock – but you don’t have to. That $400 gives you control over $6,000 worth of stock. That’s leverage.
You get a different type of leverage when you buy a put. A put option gives you the right to sell 100 shares of stock, but you don’t have to own the stock. The put buyer hopes the price of the stock goes down. If it does, the put becomes more valuable and can be sold for a profit.
As a pure speculation, buying calls or puts gives you the chance to make money on the movement of stocks, but without having to pay out big money at great risk. When you own shares of stock, the big risk is that the value might fall. So if you invest $6,000 in 100 shares of stock and its market value falls to $30, you then lose $3,000. But if you buy a call option for a premium of $4, the most you will ever lose is $400. So while you control the same 100 shares of stock, you have only a fraction of the capital at risk.
Of course, using options in this way also entails risk. If the stock price does not move in the direction you anticipated, the value of the option will drop. Even if the stock price doesn’t move at all, time works against you. The ever-looming expiration date means that value goes out of the option day-by-day, and you can lose the entire premium paid for the option. So while leverage is desirable, it comes with some amount of risk too.
Playing the Downside with Options
Many stock investors think only with a bullish perspective. But as experience has shown, stock prices across the board can decline for long periods. Owning stock when this happens can be an expensive experience. However, going long the stock is not the only way to invest in the stock market. If you think a stock will go down, you can sell the stock short.
Short selling stock is a potentially high-risk venture. When you short a stock, you believe the value will fall, and if you are right, you can then close out the short position at a profit. Short sellers open the position by borrowing the stock from their broker at a reasonable interest rate and then selling it on the open market. To close the position, they buy the stock back – the opposite of the traditional buy-then-sell pattern every stock holder knows. For short sellers, the risk is that their timing is wrong, and the market value of the stock rises. That can cause big losses, which are theoretically unlimited. So short selling may not be an appropriate strategy for most stock investors.
Using put options in place of stock to play the down market presents the same opportunity, but with less risk. When you buy puts, you make a profit if the price of the underlying stock falls. So in a bear market, put buying can be profitable – assuming the timing is right. At the same time, your risk is limited to the premium paid.
With options, you control how much risk you have. You can buy one option or several. You’re not necessarily at the mercy of a fickle market that can make or break a portfolio with devastating results. You can manage your risk by putting in only as much as you want to expose to possible loss.
The main advantage stockholders have is that they can afford to wait out the market. Even if a stock loses half its value, the stock investor can just continue collecting dividends and wait for the market to go in the opposite direction. However, while the option buyer may have less risk, they have less time also. While some options like LEAPS may have a year or two until expiration, most options last only a few months. If you don’t make your profit before expiration, you lose. That’s why it is so critical to have some basic options education and why you need to familiarize yourself with the various strategies available.