By my reckoning, buying a call option on a stock when you believe it will go up will never yield as much profit as simply buying the stock outright.
For one, the strike price is generally higher than the spot price. Additionally, you have to pay the premium to buy the call.
So, how do people make money buying options over stock? Should I be thinking about options as a sort of hedged speculation on the movement of assets?
buying a call option on a stock when you believe it will go up will never yield as much profit as simply buying the stock outright.
Suppose Apple stock is trading at $100 and you think it will go up. You have $10,000 to invest. You could buy 100 shares, and if it goes up, you'll make $100 for each dollar it goes over $100.
Also suppose that call options on apple with a strike of $100 are trading for $10. You could instead buy 1,000 options and if it goes up, you make $1,000 for every dollar that is goes over $110 ($100 + the $10 you paid for the option).
For one, the strike price is generally higher than the spot price.
Not true - you can buy options at a variety or strikes, even below the current price (these calls would be "in the money").
Additionally, you have to pay the premium to buy the call.
True. This changes your break-even point versus buying the stock. If you bought the Apple stock, your break-even price would be $100. If you bought $10 options instead, your break-even would be $110, but your profit would be 10X greater for every dollar above $110 it goes.
Should I be thinking about options as a sort of hedged speculation on the movement of assets?
That's one way to think about it. If you already own stock, you can buy puts to protect you from a drop.
In May 2016, Apple declined from a high of $130 a few months prior. I noted that it had a history of long term growth but ran in a cycle where it would drop 30% or more, then roar back.
The above trade is a spread, a bit more involved than a simple purchase. It lowered my cost, or my strike price, but also caps my profit. The easiest way to look at it, is how I describe it to my wife - "I bet $1000 that Apple will rise 50% in 18 months. If it does, we get 10X, $10,000." A 50% move gave me back a 900% return. The same $1000 would have bought 10 shares of the stock, and in hindsight, been worth $1700 when the trade closed. i.e. Apple closed at about $170 in Jan '18. Up 70%.
This is the power of leverage. Say, instead, Apple dropped further. My risk was only $1000. I was ok to lose that amount.
I always offer a warning when talking about these trades. They are not 'investing', they are gambling.
For one, the strike price is generally higher than the spot price. Additionally, you have to pay the premium to buy the call.
No, it's not generally higher. You have the choice of buying any strike price that you want.
Yes, you have to pay the premium to buy the call. They don't give options out for free. To be more specific, there are two components of premium, intrinsic value and time premium. The deeper in-the-money the option is, the lower the time premium component. High delta calls often have close to zero time premium. As an example, with IBM at $113.75, the Jan 18th 2019 $90 call costs $24 for a time premium of 25 cents.
By my reckoning, buying a call option on a stock when you believe it will go up will never yield as much profit as simply buying the stock outright.
Not that this is a good position to take (there's only a short amount of time until expiration) but buying this IBM call will give you the same upside profit as owning the stock (less 25 cents). So yes, there's never as much profit as with owning the underlying but it can be very close. Because of the lower cost for the call, that means that there's a much higher ROI. If one were to buy OTM calls, the leverage increases as does the ROI if the underlying rises a lot.
It also offers less risk should IBM collapse. Below $90, the call loses nothing more than the stock. The share holder keeps losing as IBM drops. Should IBM drop to $25 tomorrow, the call would have some salvage value and would lose about $2 less than the stock lost.
If the call was for a longer expiration, perhaps April, then due to time premium retention, an Apr 18th $90 call would have a higher salvage value and would lose even less than the January call.
And one subtle point. In the event of such a drop, implied volatility would expand, increasing the time premium of the call, thereby further reducing the call's loss as compared to the stock.
Each contract involves 100 shares/units, so there's effectively some leverage built in which is reflected in day to day changes relative to the underlying asset but not at all in long term tracking.
To pick on Apple as an example, Yesterday, 1/2/2019, Apple closed at $157 today it opened at $143 and that's roughly the price now; that's a decline of ~9.7%.
If you were holding a January 4 put on apple with a strike price of $150 (this contract allows you to sell 100 shares of apple for $150 per share), that contract price changed from about $0.10 per share ($1 contract) to $7 per share ($700 contract) which is an increase of ~7000%. The contract is worth about $7 because apple is trading at $143 which is $7 less than your strike price of $150 and there is very little consideration left for time as the contract expires tomorrow.
If you were holding a January 17, 2020 put on apple with a strike price of $150, that contract price changed from about $15 ($1,500 contract) per share to about $21 per share ($2,100 contract). This is a 40% increase; which you are free to capture by simply selling your contract.
Apple moved about 10%. A contract expiring tomorrow moved 7,000% and a contract expiring in a year moved 40%. The contract expiring in a year still has a lot of time premium in it relative to the contract expiring in a day.
Bear in mind that in the example of the contract expiring tomorrow, that was worth $0.10 yesterday, had apple not fallen from yesterday's close of $157 through your strike price of $150 to become "in the money" it would have expired at $0. Because no rational person would ever use that contract to sell their 100 shares of apple valued at $15,700 by the market for the $15,000 indicated by your put contract.
When you transact an option, the four major variables are:
The strike price is not generally higher than the spot price. The strike price is whatever price is indicated on the contract you bought and does not change.
To your last paragraph. Generally, options are not for investing they are for trading and hedging. Options have contract premium and time decay, at the retail level you can buy pretty long contracts, and buying puts can be a lower risk short-like position but these are not long term investments.
When you're investing the idea is to be in the investment for a long time, you're not going to be in an option for a long time.
Buying an option, or a future, allows an investment to be held with a smaller amount of funds. If the investor is correct about the investment, but has only a small amount of funds, then some position is better than no position.
Also, an option is a set amount of financial cost or risk. A future, on the other hand, could require additional investment to hold the position. Both options and futures have long-term contracts available.
