Buying stocks is almost always a less risky strategy than buying options. When you buy a stock, you are making an investment in a company and you can hold that investment indefinitely. You own a piece of the company for as long as you believe the underlying fundamentals of that company are positive and the stock price will increase. However, when you buy an option, your holding period is limited to the date the option expires. If you make money during that time period, great. If not, you’ve lost the money you invested to purchase the option and that’s it.
What Are Options?
An option is a contract to either buy a stock or sell a stock at a specified price during a specified time period. It’s a contract between two entities, so for every buyer there is a seller and vice-versa. A call option gives you the right (but not the obligation) to buy the stock and a put option gives you the right (but not the obligation) to sell a stock. You can either buy or sell a call option and you can either buy or sell a put option. If you are bullish on the market, you would either buy a call option or sell a put option. Conversely, if you are bearish on the market, you would buy a put option or sell a call option. You don’t need to own the underlying stock to trade the option.
The advantage of trading options versus stocks is the use of leverage. You don’t need to invest as much money in order to participate in the movement of a stock, either up or down. Each option contract represents 100 shares of a stock and has an exercise or strike price and expiration date assigned to it. Most options expire within three, six or nine months. The strike price depends on the price of the underlying stock and varies as the stock price fluctuates. It can be lower or higher than the current market price of the stock. The current market price of the option is called the “spot” price. For example: buying 100 shares of a stock trading at $100 a share would cost you $10,000. But buying one option contract on that same stock with a strike price of $110 that expires in six months might only cost you $1000. These aren’t actual prices, but you can see how much less needs to be invested in order to participate in the movement of a stock.
Buying Options and Selling Options
Buying options is usually less risky than selling options because your loss is limited to the amount you paid for that option. But selling naked options can actually expose you to unlimited loss. (Selling naked options means you don’t own the underlying stock.) There are many option strategies that use combinations of selling and/or buying puts and/or calls and some are riskier than others. You would trade options in an option account, and if you trade naked options, you would need a margin account as well.
One of the less risky option strategies is called “covered call writing.” For example, you own a stock that has increased in price but you don’t want to sell it because of the capital gains tax or some other reason. However, you also think the market may be going down and it could affect the stock price. So, you sell a call option against your stock and receive a premium for that option. If the stock does go down, then the option will probably expire worthless and you keep the premium. However, if the stock goes up in price, you may have to sell the stock if the buyer of the call option exercises his right. Before that happens, you can buy back the option and keep your stock, so your only cost was the difference in the initial premium received and the amount you had to pay to buy back the option.
Now let’s say you sell a naked call option on XYZ stock when the price of the stock is $100 but you think the price is going down. Someone bought that option from you because they thought the price was going up. So, before the option expires, the stock moves to $120. Now the buyer uses his call option to buy the stock from you at $100. You then have to go into the market and buy it for $120 and sell it to him for $100. You’ve lost money obviously, but the stock could have moved much higher so the potential for loss is unlimited. If you had owned the underlying stock and sold that option, you could just deliver the stock to the buyer of the option as we discussed in the covered call writing example above.
Trading options is not easy and should only be done under the guidance of a professional who not only has the knowledge but also the experience in this area. As mentioned at the beginning of this article, the simple and less risky strategy is always to buy the stock.