Originally posted at The Options Zone
When it comes to investments, most people have the idea that owning stock is a sound and prudent thing to do. In fact, the Prudent Man Rule tells us that not investing a significant portion of one's assets in a diversified stock portfolio is imprudent.
Owning options is different. Hardly anyone considers the strategy of buying options to be less than speculative. To some, it's outright gambling. In this discussion, I only mention call
options. Why? Traditional investors buy stock and probably never
consider selling them short. Thus, a post relating to investing in
stocks must be from the stockholders perspective. And that means owning
calls, not puts.
I don't like the idea of owning options as an investment, and never suggest that anyone invest that way. The rationale behind my stance is that the vast majority of option buyers pay far too much in time premium, in effect placing a wager that the specific stock will move sharply higher soon, or before the option expires. That is gambling and not investing. A stockholder can afford to wait for his/her reason for buying the stock to be recognized by the market. The individual investor who buys options cannot afford to wait as time erodes the value of those options.
For the small minority who have proven skills as a market timer, owning at-the-money or out-of-the-money options may prove profitable. But buying those options is a trap for the average individual investor.
On the other hand, if a trader buys call options that are already in the money by several points, the picture is entirely different. These options have a high delta (75-85) and increase in value at a pace that almost matches that of the stock. Obviously owning calls is less profitable when the hoped-for rally occurs. However the profit from that rally is 'good enough' when you consider that there is a big benefit that comes with owning these options.
In return for paying time premium, the call buyer gains a big advantage. Specifically, loss is limited to the price of the call. In a market downturn, instead of being exposed to a large loss (example, a $42 stock declining to $25), the owner of the call with a $35 strike price can lose no more than the option premium. That amount varies depending on the stock's volatility and the remaining lifetime in the option, but it's likely to be in the $1 to $2 range, plus intrinsic value).
It's a trade-off that is not suitable for every investor. But if you are willing to sacrifice a little upside potential in return for additional protection in a down market, these calls are suitable investments. See a recent post on stock replacement.
If you heard of the strategy referred to as buying 'protective puts,' this is an identical approach. Buying one put per 100 shares of stock is a method that is equivalent to owning the call option – with the same strike and expiration date. When you consider trading costs, it's more efficient to buy calls than to buy stock and puts.
I am not trying to convince investors with long-term investment objectives to switch from stock to options. My purpose is to compare stock with options and be certain that you recognize what you get when buying stock.
Let's consider that $42 stock mentioned above. It pays no dividend. The table indicates the value of a 6-month call option, assuming the options trade with an implied volatility of 35.
Buyers of the 6-month 35 call option pay $148 per contract in time premium. Investors who hate paying anything for time premium may prefer the 6-month 25 call, which carries a time premium of only $29. By buying this call with a lower strike price, you accept an additional downside risk of $1,000 per option.
For investors who insist on paying zero extra premium, and who are willing to take even more downside risk (but it's a small risk. There is little likelihood that this stock can move below $25 – but it is possible) there's the 6-month call option with a strike price equal to zero. Such options don't trade on any of the option exchanges, but they do trade on the New York Stock Exchange. These options with a strike price of zero come with a bonus. They never expire. They are called stock.
The point of this exercise is to illustrate that buying ITM options is not so different from buying stock. I've seen brand new investors buy low-priced stocks for the simple reason that they cannot afford to buy higher priced stocks. That's a big mistake. It's much better to buy a few shares of a stock you truly want to own than being forced to choose from the universe of low-priced stocks. That trader ought to understand that buying ITM $8 call options on quality stocks is better than buying $8 stocks.
A recent discussion with a reader prompted this post. He is willing to invest cash in a stock position, but considers his option purchases to be speculative and uses far less cash when buying options. That makes sense – from his perspective. Without so-stating, it's clear: this trader buys low-priced ATM or OTM options. The thought of owning deep ITM options instead of stock was not considered. This post is dedicated to him and other stock owning investors. Please keep in mind that call owners do not collect dividends and this discussion is targeted to non-dividend paying stocks.
The two Mark's disagree over the idea of 'playing with house money" in the Pro & Con column.
Tyler Craig contributes a guest column and offers his take on the popular strategy of writing covered calls.