Most active traders have heard fantastic tales of how another trader used stock options and made 300% or more in just two weeks. These stories are common among option traders. However, just as common are the stories about people who bought a stock option and lost everything. The end result is a divided set of opinions among traders regarding the practical use of stock options. Some think everyone should trade options, and others think absolutely no one should trade options. So what’s the reality? There are good things about trading options, there are bad things about trading options, and there are ugly things when it comes to trading options.
There are three main reasons people choose to buy stock options:
Relative to trading the underlying stock itself, stock options are cheap. When you consider many of the great stocks cost $75-$150 a share to buy, and you can buy a stock option for just $2-$5 a share, it’s not difficult to see why so many traders would gravitate towards trading the option. Options allow traders with smaller accounts to control more expensive stocks for a fraction of the price.
Drawdown is the amount of money that your overall account loses when the trade goes down. When it comes to risk management, we say that drawdown should not be more than 2-5% of your overall account. The way we figure drawdown is with the following formula:
Entry price - Stop price = Drawdown
On the graphic below, if we placed a market entry price of $102.95 and we placed a stop below our recent swing low, around $96.50, we would have a potential drawdown of $6.45 per share.
When you use the stock option to make the trade, it is impossible to lose more than you have paid for the stock option. So if you bought the option with three months to expiration and paid $5.45/share, and even if you lost all of it, it would be less overall account drawdown than buying the stock.
The good news is you don’t need to lose all of it. I’m just making the point that you would still be ahead if you did lose all of it. But with the option, you could set the same “stop price,” meaning if the stock gets down to $96.50, you stop out, but your overall dollar for dollar account drawdown would not be the same.
It can be difficult to estimate precisely what our future option price would be if the stock dropped $6.45 but using this option projection too, we can anticipate a move down of $6.45 in the stock would cause our option to lose about $3.59 of value as opposed to the total $6.45 lost if we bought the stock. The option would be less damaging to your overall account if you held the option vs. the stock.
Finally, let’s talk about ROI. When you buy a stock option, the ROI is much better if the trade goes in your favor. Let’s assume our current trade increases to $110 a share over the next 2-3 weeks. If you buy the stock at $102.95, your profit will be $7.05 a share: a good profit and a solid return on investment.
But the same trade done using options would yield a much higher ROI. Assuming we purchased the $100 Call option with three months to expiration, we would pay approximately $5.45 a share for the option. We can use this option projection chart to see the future possibility of the trade. If the stock rises to $110 over the next 2-3 weeks, this option will be worth approximately $10.50 a share, a profit of $5.05 a share. While dollar for dollar, we would make just a little bit less with the option trade, in terms of capital at risk, our ROI is substantially higher.
Unfortunately, leverage can be a double-edged sword as it means things are happening faster. In trading, this means you can profit twice as fast, but you can also lose twice as fast. I first discovered leverage when I learned about margin trading. When trading on margin, you immediately get twice the buying power. For 50% of the capital, you can control 100% of the stock. This means the ROI is double when the trade goes up. But when the trade goes down, the loss is double as well.
Options are similar. Options provide leverage because they allow you to control a large amount of stock for a fraction of the price. When the trade goes up proportionally, it creates a huge ROI. But when the trade goes down, it creates a larger loss percentage of capital at risk. That’s an important distinction. The ROI loss is of the capital at risk. If you compare it to your overall account and use good money management, it does not need to impact your overall account the same way it impacts the individual loss.
Let’s assume someone buys a $100 stock, and the trade goes down to $90, and they stop out. This represents a $10/share loss, or 10% of their capital at risk. If the trader had instead spent $5 to buy a 100 Call option, and the trade goes down to $90, the option would probably be worth $0 or pretty close to $0. This would represent a 100% loss vs. 10%.
Many people look at options this way and immediately think the risk is not worth the reward. But let’s think about this in terms of risk management. Let’s assume for a moment you have a $200,000 account. Using our basic money management rules, you can risk as much as 5% of your account to draw down on a single trade. If you have a $200,000 account, that means you can sustain up to a $10,000 loss on any one trade. If your stop is at $90, and you plan to buy at $100, you can invest $100,000 and stay within your risk tolerance on the trade.
But if you could buy the option for just $5 a share, you could place a 1000 share order and invest only $5,000. Now, if the trade goes down to $90, your option becomes worth $0, a $5,000 loss. Sure, that’s 100% of your investment capital. But if you bought the position with stock, you would have sustained a $10,000 loss, twice the dollar amount.
The ugly truth about options is that they are a decaying asset. When you buy a stock, your ownership will not cease to exist. Even if the stock goes down, you still own it. But with a stock option, there is a clock that is counting down. Once expiration day comes, that option ceases to exist. If you don’t have a profit in the trade by that point, you’re done.
This introduces a new component of trade management. Not only do we have to think about account drawdown, but we also have to use time management to manage the calendar. My general rule is to sell the option two weeks before expiration regardless. The last two weeks are the most difficult because of the time decay curve. As you can see in this image below, the last two weeks are when the time decay curve accelerates, and it makes it very difficult to make money buying options.
Even though time decay is an ugly part of options, it is manageable, but it does make it more difficult. For this reason, a lot of people choose to become an option seller rather than an option buyer. Option selling puts these odds in your favor but takes on a new risk of being short options. Both positions have their advantages; however, neither is perfect in every scenario.
Stock options are a powerful tool available to traders. When appropriately deployed, they can provide significant income opportunities. As an option buyer, the odds are somewhat set against you; however, the use of the option can lower your capital risk, lower your capital requirements, and increase your ROI. As an option seller, the odds are more heavily in your favor. However, if you misuse the tool or miscalculate the trade direction, you could end up with a very unfavorable drawdown on your account. At the end of the day, using stock options as a trading tool is a personal choice, and each trader needs to fully understand the risks of options and the benefits before entering trades with them.