Why Trade Stock Options?

Summary:
Stock options because of the leverage they provide in terms of enabling you to invest less capital and realize substantially higher comparative returns on a percentage basis, when compared to buying stocks outright, should be a part of most investors portfolio – assuming of course you haven’t reached an age where for prudence sake, your portfolio should be comprised of wholly ultra conservative investments. . 

Options are derivative financial instruments that are based on an underlying instrument, which in the case of equity options, the underlying will be stocks. The simplest option strategy is to buy either calls or puts. Should the investor buy calls, she is hoping the price of the underlying rises and depending on the strike price of the calls and the level of move in the underlying, the investor realizes a profit when the underlying rises. The opposite is true, if the investor purchases puts. In other words, if the investor purchases calls, she is betting/hoping the underlying rises, and if the investor purchases puts, she is hoping the price of the underlying falls.

Most people that buy calls and/or puts, buy those calls and/or puts to realize the profits generated on those options, if the stock moves in the direction they were hoping. With the underlying stock moving in the direction they were hoping, the options will move up as well, and the investor can then sell those options at a profit.

However another reason for buying calls is so that you can lock in the stock at a lower price and a reason for buying puts is to lock in the stock at a higher price. How does this work? Well let’s say you like XYZ stock, which is currently trading at $40. If you think the stock will be moving to $50 over the next couple weeks, you would buy the calls. If the stock does move to $50, because you have those calls, you can exercise them and your purchase price for the stock will be $40.

On the other hand, if you own XYZ, which is currently at $40 and you think the stock might decline in price, or simply because you own them you want to protect against a drop in price, you could buy the $40 puts. If the stock goes down to say thirty-five, you could exercise the position which then gives you the right to sell the stock at the higher price of $40.

Keep in mind that each option contract controls a hundred shares of the underlying stock, so if you purchase one call, you have the right to buy a hundred shares of the underlying and if you purchase one put, you have the right to sell one hundred shares of the underlying.

Buying a call gives the buyer the right, but not the obligation to buy the underlying stock at a certain price (the strike price) at any time between the time the option is purchased and when they expire. Puts give the purchase the right, but not the obligation to sell the underlying stock at a particular price at any time between the time the option is purchased and when they expire. This article by the way, deals with American style options which can be exercised at any time during the life of the option contract. European options on the other hand, can only be exercised at expiration.

The next obvious question is: why not just buy a stock if you think there will be an appreciation in the share price or why not just short the stock if you think the share price will fall? Well, therein lies the beauty of options. They allow you to leverage your investment dollars and if you make the right call, the profit you'd make trading the option on a stock, is greater on a percentage basis, than the profits you'd make just trading the stock.

Here is an example of a previous trade that we recently selected for subscribers to Navivest’s Options Capitalist:

In the Wednesday May 28th, 2008 issue, we recommended that our subscribers purchase the June 15 calls in Marvell Technology Group as the company was coming out with earnings on the 29th that we felt would be relatively decent.  The stock was at $14.34 as of the close of Wednesday May 28th. On Thursday, during the trading day, the stock traded within a tight range so our subscribers were able to purchase the options at Wednesday’s closing price and within our recommendation range. Thursday evening, the company came out with earnings that blew away Wall Street expectations.

On Friday as a result of the earnings, the stock gapped up and opened at $16.98 from the previous close of $14.08 for a 20.59% gain, which is an incredible move, especially in just twenty-four hours. The stock actually ended up closing at $17.6, for a 23.93% gain on the day. At those prices, the June 15 call options that we'd recommended to our subscribers, gained 716% in one day! A ten thousand dollar position on Thursday morning was worth $81,600 on Friday evening. The amazing thing is, this is not unusual. Just about everyday, there are options that realize double and triple digit gains.

The beauty of options is that you don’t have to find stocks that will move twenty plus percent in one day. Here is an example of the profit potential if an investor purchases IBM June 2008 125 puts, which at the close of trading on Friday May 30th, are trading at around $.75. The stock itself is at $129.43. If IBM moves down just four points by next Friday June 6th, the options will then be worth about $2.00, which is an appreciate by roughly one hundred and sixty percent in one week! Remember that the stock itself has only moved three percent.

It is important to note that there are a few variables that affect the price of an option. Time for one, will cause what’s known as time decay. In other words, say you buy a call option today and over the next week, the stock price stays the same, which would mean the option does not appreciate, then your options will actually be worth less than what you paid. Also, how much the option moves in relation to the stock depends on the Delta, which is one of what is know as the Greeks, that have a major effect on your options. However, for the most part, any decent move in the underlying will move the options.

As to why trade options? Well the long and short of it is that it leverages your investment dollars. IBM for instance, is currently at $129.43 (Friday 05/30/08 close.) To buy a thousand shares will cost one hundred and twenty nine thousand dollars. Further more, if the stock moves down four points over the next five trading days, you’ve made just four thousand dollars. Of course, earning four thousand dollars in one week is way better than putting your money in the bank and earning two thousand in one year. However, if you'd decided to trade the options instead and you use just ten thousand dollars, that same four-point move will increase your investment portfolio by about seventeen thousand dollars. As you can see, you just leveraged your capital considerably. Below is a graphic illustrating the profit potential of the IBM June '08 130 calls.

It is very important to note that there are quite a few things an investor should know before trading options on their own. Without any prior experience in trading options, we suggest that you read up on options and study them quite a bit before trading them. They can be tricky if you don’t know what you are doing and risk of capital can be quite high. Also, there is a myriad of option strategies that an investor should know about before trading options. There are even ways to formulate a trade so that you all but eliminate the downside. So spend time studying.

Navivest is a stock and options trading advisory services company. We offer several subscription-based services for traders and investors as well as Free Trades of the Week trading ideas on the Navivest website.

Options resources on the web:

www.optionseducation.org. Options education site by the Options Industry Council.

www.forbes.com/option. More options education, from Forbes magazine.