2

Assuming I enter a stock at $100/share. The stock goes up 3% over the course of two days, I then sell the stock and collect my profits. How would this compare to me buying a call option contract for the same stock and profiting off of the option by it going up 3% and exiting at essentially the same point as the normal stock? I was wondering if somebody with experience in options can basically compare how all phases would pan out for the options route (entering the market, setting a trailing stop, exiting the market, etc) and how it compares to simply buying stock - while taking in to consideration the trading fees, option premiums, other costs associated with each approach.

whichever route I take - stocks or options and I am trying to determine which is most suitable for me assuming the stocks I pick profit anywhere from 3-5%.

I appreciate any clarification.

  • 7
    The very simple answer is that options are much more highly leveraged than stocks. If you buy the option and the stock goes up (now, before expiration) you make a lot more money. If it doesn't go up before expiration, you lose everything. If you buy the stock and it doesn't move, you don't lose anything. If you buy the stock and it goes up, you gain the small percentage. This is all before allowing for commissions. – Ross Millikan Nov 24 '15 at 5:06
  • @RossMillikan I think your comment might be the best answer posted so far. – Ixrec Nov 24 '15 at 13:30
  • 1
    Kep in mind that there is massive arbitrage. If one type of investment would certainly be more profitable than another, arbitrage would quickly erase the difference. This is one of the hidden benefits of High Frequency Trading - it greatly reduces the chance that you're buying too high or selling too low. A bot would have undercut high sellers and outbid low buyers. – MSalters Nov 24 '15 at 13:43
  • options, using the same amount of capital as buying a stock outright, theoretically. – CQM Nov 24 '15 at 14:26
  • @MSalters - for a rising stock, a leveraged position " would certainly be more profitable than" one that's unleveraged. No idea why you think arbitrage would somehow change this. I'm probably misunderstanding your comment. – JoeTaxpayer Nov 24 '15 at 17:37
3

Nearly 3 years ago, I wrote an article, Betting on Apple at 9 to 2 which described a bet in which a 35% move in the stock returned 354% on the option trade. Leverage works both ways, no move, or a slight move down, and the bet would have been lost. While I find this to be entertaining, I don't call it investing.

With $2-$3K, I recommend paper trading first, and if you enter option trades, no one trade should be more than 20% of this money. If you had $50K in betting money, no position over 10%.

  • What if that stock move was just 3%, how would the option pan out in comparison? – AnchovyLegend Nov 24 '15 at 3:28
  • However, Joe, Options can also be used as a way of limiting your losses. If the OP bought $10k worth of shares and the shares fell by 20% in a week they would have lost $2k. If they took out the same exposure with options paying say $1000 premium, then they are limited in losing only that $1000 in premium. Of course where most inexperienced option traders go wrong is that they buy $10k worth of options and then are horrified when they lose it all. The greed gets to them, and of course this then turns to fear when they make such a big loss. – Victor Nov 24 '15 at 6:25
  • @AnchovyLegend - if you see the article I linked, the details are clear, the bet was for options that had 2 years to run, and was to be a total loss up to a stock gain of 12% over that time. Apple was $446, and I bet that it would rise to $600. My return was linear from $500-$600, $0-$10K. You can study the pricing for different strikes and expiration dates to get different leverages. A 3% move in a short time might be profitable depending on the stock. For some stocks, the option premium may make the move a loss. – JoeTaxpayer Nov 24 '15 at 12:39
  • @Victor - agreed. Options offer a way of shifting the risk/reward profile in either direction. My example turned a 2 year 35% move into 10 times that return. On your $10,000, keeping $9K invested conservatively, the $1K bet would have returned $4500. I have another trade, not written yet. A 60% return in 1 yr for flat stock price. Stock drops 30% and deal is break even. A covered call. Will update after I write article. – JoeTaxpayer Nov 24 '15 at 19:39
2

The first thing that I learned the hard way (by trying my hand at actual options trading) is that liquidity matters. So few people are interested in trading the same options that I am that it is easy to get stuck holding profitable contracts into expiration unless I offer to sell them for a lot less than they are worth.

I also learned that options are a kind of insurance,and no one makes money (in the long run) buying insurance.

So you can use options to hedge and thereby prevent losses, but you also blunt your gains.

Edit: IMO,options (in the long run) only make money for the brokers as you pay a commission both on the buy and on the sell. With my broker the commission on options is higher than the commission on stocks (or ETFs).

  • Options are an open, transparent market, practically speaking. They're a zero-sum game, unlike insurance which is closed and opaque. – MSalters Nov 24 '15 at 13:33
1

First, to mention one thing - better analysis calls for analyzing a range of outcomes, not just one; assigning a probability on each, and comparing the expected values. Then moderating the choice based on risk tolerance.

But now, just look at the outcome or scenario of 3% and time frame of 2 days. Let's assume your investable capital is exactly $1000 (multiply everything by 5 for $5,000, etc.).

A. Buy stock: the value goes to 103; your investment goes to $1030; net return is $30, minus let's say $20 commission (you should compare these between brokers; I use one that charges 9.99 plus a trivial government fee).

B. Buy an call option at 100 for $0.40 per share, with an expiration 30 days away (December 23). This is a more complicated. To evaluate this, you need to estimate the movement of the value of a 100 call, $0 in and out of the money, 30 days remaining, to the value of a 100 call, $3 in the money, 28 days remaining. That movement will vary based on the volatility of the underlying stock, an advanced topic; but there are techniques to estimate that, which become simple to use after you get the hang of it. At any rate, let's say that the expected movement of the option price in this scenario is from $0.40 to $3.20. Since you bought 2500 share options for $1000, the gain would be 2500 times 2.8 = 7000.

C. Buy an call option at 102 for $0.125 per share, with an expiration 30 days away (December 23). To evaluate this, you need to estimate the movement of the value of a 102 call, $2 out of the money, 30 days remaining, to the value of a 102 call, $1 in the money, 28 days remaining. That movement will vary based on the volatility of the underlying stock, an advanced topic; but there are techniques to estimate that, which become simple to use after you get the hang of it. At any rate, let's say that the expected movement of the option price in this scenario is from $0.125 to $ 1.50. Since you bought 8000 share options for $1000, the gain would be 8000 times 1.375 = 11000.

D. Same thing but starting with a 98 call. E. Same thing but starting with a 101 call expiring 60 days out. F., ... Etc. - other option choices.

Again, getting the numbers right for the above is an advanced topic, one reason why brokerages warn you that options are risky (if you do your math wrong, you can lose. Even doing that math right, with a bad outcome, loses).

Anyway you need to "score" as many options as needed to find the optimal point. But back to the first paragraph, you should then run the whole analysis on a 2% gain. Or 5%. Or 5% in 4 days instead of 2 days. Do as many as are fruitful. Assess likelihoods. Then pull the trigger and buy it.

Try these techniques in simulation before diving in! Please!

One last point, you don't HAVE to understand how to evaluate projected option price movements if you have software that does that for you. I'll punt on that process, except to mention it.

Get the general idea?

Edit P.S. I forgot to mention that brokers need love for handling Options too. Check those commission rates in your analysis as well.

1

More perspective on whether buying the stock ("going long") or options are better. My other answer gave tantalizing results for the option route, even though I made up the numbers; but indeed, if you know EXACTLY when a move is going to happen, assuming a "non-thin" and orderly option market on a stock, then a call (or put) will almost of necessity produce exaggerated returns. There are still many, many catches (e.g. what if the move happens 2 days from now and the option expires in 1) so a universal pronouncement cannot be made of which is better. Consider this, though - reputedly, a huge number of airline stock options were traded in the week before 9/11/2001. Perversely, the "investors" (presumably with the foreknowledge of the events that would happen in the next couple of days) could score tremendous profits because they knew EXACTLY when a big stock price movement would happen, and knew with some certainty just what direction it would go :(

It's probably going to be very rare that you know exactly when a security will move a substantial amount (3% is substantial) and exactly when it will happen, unless you trade on inside knowledge (which might lead to a prison sentence). AAR, I hope this provides some perspective on the magnitude of results above, and recognizing that such a fantastic outcome is rather unlikely :)

Then consider Jack's answer above (his and all of them are good). In the LONG run - unless one has a price prediction gift smarter than the market at large, or has special knowledge - his insurance remark is apt.

  • Thanks. I should explain that I, initially, got into options as a way to make 'investing' more exciting. But just like a casino that excitement comes at a price. In the long run you lose more than you gain. The most reliable way to make money in the stock market is boring, boring, boring. That best way is to buy a dividend paying security, never sell it, and reinvest the dividends. It is, almost, a hands off approach. As said, it is quite boring, but it is how Warren Buffet has accumulated his wealth. – Jack Swayze Sr Nov 24 '15 at 10:46
1

As already noted, options contain inherent leverage (a multiplier on the profit or loss). The amount of "leverage" is dictated primarily by both the options strike relative to the current share price and the time remaining to expiration. Options are a far more difficult investment than stocks because they require that you are right on both the direction and the timing of the future price movement.

With a stock, you could choose to buy and hold forever (Buffett style), and even if you are wrong for 5 years, your unrealized losses can suddenly become realized profits if the shares finally start to rise 6 years later. But with options, the profits and losses become very final very quickly. As a professional options trader, the single best piece of advice I can give to investors dabbling in options for the first time is to only purchase significantly ITM (in-the-money) options, for both calls and puts. Do a web search on "in-the-money options" to see what calls or puts qualify. With ITM options, the leverage is still noticeably better than buying/selling the shares outright, but you have a much less chance of losing all your premium. Also, by being fairly deep in-the-money, you reduce the constant bleed in value as you wait for the expected move to happen (the market moves sideways more than people usually expect).

Fairly- to deeply-ITM options are the ones that options market-makers like least to trade in, because they offer neither large nor "easy" premiums. And options market-makers make their living by selling options to retail investors and other people that want them like you, so connect the dots. By trading only ITM options until you become quite experienced, you are minimizing your chances of being the average sucker (all else equal).

Some amateur options investors believe that similar benefits could be obtained by purchasing long-expiration options (like LEAPS for 1+ years) that are not ITM (like ATM or OTM options). The problem here is that your significant time value is bleeding away slowly every day you wait. With an ITM option, your intrinsic value is not bleeding out at all. Only the relatively smaller time value of the option is at risk. Thus my recommendation to initially deal only in fairly- to deeply-ITM options with expirations of 1-4 months out, depending on how daring you wish to be with your move timing.

  • +1 - But OP was asking how to profit from a fast 3% move. You and I both answered with advice on long term option positions. Interesting. – JoeTaxpayer Nov 24 '15 at 12:46

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.