Compared to other financial instruments, options are actually fairly new. Since coming to the exchanges in the early 1970s, options have developed a reputation for being high-risk investments. But the same could be said of any derivative.
The truth is, a tool is only as dangerous as the person using it. A scalpel in the hand of a child is an implement of destruction, but in the hand of a surgeon, it’s a precision instrument. If you understand how options work and know where they fit in your trading strategy and goals, they can be highly effective instruments to goose your returns.
For experienced traders, options have four distinct advantages over stocks. First, as leveraged instruments, options are more cost efficient. Through the use of leverage, you can control a much larger position at a fraction of the price. You are, in effect, leasing the equity’s profit potential for a particular period of time as opposed to owning the equity outright.
If you have $50,000 in your brokerage account and you want to take a position in ABC, which is trading for $100, you could buy 500 shares outright and wipe out your account balance. Or you could buy call option contracts with a strike price of $100 that expire in six months for $400 and control the same number of shares for $2,000, leaving you $48,000 to pursue other opportunities.
Note: Options contracts are typically for 100 shares, so if the options premium is $4, a contract would cost $400.
The second advantage may seem counterintuitive, but options can actually be less risky than owning stock—for a number of reasons. First, in the example above, imagine that you hold your options until the expiry date, and the night before the contract expires, the price of ABC drops to $40. Even though you control 500 shares, you’re still only out by the cost of your contract, or $2,000.
If you owned the shares and the stock dropped $10 overnight as in the example above, you’d lose the full $5,000 from your account balance.
Note, however, that you are not required to hold options contracts until expiry; you can trade them at any time, just as you could exit your stock position at any time.
Options are also an extremely effective hedge, which also makes them less risky than stocks. Most investors place a stop-loss order when they open a position in order to protect it against excessive loss. In the example above, if you bought ABC at $50, you’d place a stop-loss at $45 to limit your losses to 10%.
Taking the example above a step further, imagine your stock drops to $30 overnight on breaking news of a massive class-action lawsuit. Even with the stop-loss order at $45, it will still be sold for $30 first thing in the morning, because it’s the first trade below your $45 stop limit. Now your loss isn’t just on paper, it’s a fully realized loss of $10,000.
If you’d hedged your position with a put option at $45, this wouldn’t have happened, because an options contract gives you the right to sell the stock for $45 on or before the expiry date no matter how low the price goes.
Finally, your returns potential is exponentially higher with options, because you’re earning similar gains in terms of actual dollars while risking a fraction of the cash, i.e. as a percentage, your options returns are going to be much higher with winning options trades.
Let’s look at ABC in the example above again. Imagine now that ABC successfully launched an amazing new product that the public is going wild for, and the stock jumps $10 to $60. If you owned the stock, you’d realize a gain of $5,000, or 10%.
With options, the equation looks like this: Your options contract has 0.75Δ (delta), which means that for every $1 movement in stock price, your option price will increase $0.75. So a $10 price movement translates to a $7.50 movement in your options, or $3,750 on your five contracts. Given your initial investment of $2,000, you just made 187% on your trade.
Bottom line, options are a great strategic tool for short-term trades. In the hands of a knowledgeable trader, they can be used to diversify a portfolio, hedge your positions, and goose your returns.