Most traders have heard stories of how someone used stock options to make 300% or more in a concise amount of time. 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. However, as with most things in life, the truth falls somewhere in the middle as 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. There is a lower capital requirement, a lower overall drawdown, and a potentially higher Return on Investment or ROI.
Relative to trading the underlying stock itself, stock options are cheap. Options allow traders with smaller accounts to control more expensive stocks for a fraction of the price. 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 toward trading the option.
Drawdown is the amount of money 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 a share, and even if you lost all of it, it would be less overall account drawdown than buying the stock.
Usually, 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, our ROI is substantially higher in terms of capital at risk.
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. 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 considerable ROI. But when the trade goes down, it creates a more significant 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.
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. One general rule when trading in options 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. Options 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, each trader needs to fully understand the risks of options and the benefits before entering option trades.