Most active traders have heard fantastic tales of how such and such 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 result is a fairly 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.
What’s the reality?
Today I’m going to share with you the reality about stock options. We’re going to talk about:
...and the downright ugly!
So here we go.
There are three main reasons people choose to buy stock options:
• Lower capital requirement
• Lower overall drawdown
• Higher ROI
Each of these components adds up to equal one great benefit: LEVERAGE
Here's the formula:
Lower Capital + Lower Drawdown + Higher ROI = LEVERAGE
Okay, that's not exactly the textbook definition of leverage, but it does describe the reasons people want to buy options. They provide better, more efficient use of investable cash. Let's investigate how.
Relative to trading the underlying stock itself, stock options are cheap. When you consider many of the great stocks cost $75-$150/share to buy, and you can buy a stock option for just $2-$5/share, it’s not difficult to see why so many traders would gravitate to trading the option.
I heard one trader say it this way:
“I don’t want to play in the ‘hood,’ and options allow me to play with the big boys without having all the money.”
This sentiment is real, and it’s true. Options allow smaller traders to take control of more expensive stocks for a fraction of the price.
Take AAPL for example:
Apple Computer is one of the most popular and heavily traded stocks. But the cost is almost $100/share (it was almost $700/share before the split in 2014).
For most average traders, taking a large position in AAPL is prohibitive. Even though that’s what a lot of traders want to do, they instead look for cheap stocks or penny stocks because they can afford to buy more than a few shares.
With a stock option, all of that changes.
Look at this option chain:
Here, you see the cost of buying a call option is a fraction of the cost of buying the stock. An option trader can get control of this $100 stock for only $4.30, or for just $5.45 they can get control for nearly three months!
For a swing trader, this makes much more sense. Most swing traders only plan to be in a trade for a few days up to a few weeks, so putting up $100+/share for a stock simply doesn’t make sense when you can get control of the same trade for around $5/share.
Bottom line: It’s cheaper to buy a stock option than to buy the stock.
Drawdown is a very important factor when considering a trade. Stock options help traders by reducing the drawdown.
For those of you who may not be familiar with the term, drawdown is the amount of money that your overall account loses when the trade goes down. So if you have a $10,000 account and you lose $500 on a trade, your drawdown is 5% of your account.
When we do 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 this AAPL trade, if we placed a market entry price of $102.95 (market price on the chart) and we placed a stop below our recent swing low around $96.50, we would have a potential drawdown of $6.45/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 if you did lose all of it, you would still be ahead. 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 exactly 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 full $6.45 lost if we bought the stock). The option would be less damaging to your overall account (dollar for dollar) 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 this trade on AAPL increases to $110/share over the next 2-3 weeks. If you buy the stock at $102.95, your profit will be $7.05/share. Not a bad profit and frankly not a bad ROI.
But the same option trade would yield a much higher ROI.
Assuming we purchased the $100 Call option with three months to expiration (October), we would pay approximately $5.45/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/share, a profit of $5.05/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.
Here you see the good of buying stock options. With the option you can:
All of that adds up to create GREAT LEVERAGE!
If that was the entire story, then everyone would be an options trader. Unfortunately, this does not tell the entire story. So let’s look at the “bad” part of trading options.
Leverage is a double-edged sword. Leverage means things happen 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 trading on margin. 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, for the capital at risk, 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 that 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%.
A lot of 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 rules of money management, you can risk as much as 5% of your account to drawdown 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 (1000 shares) and stay within your risk tolerance on the trade.
But if you could buy the option for just $5/share, you could place a 1000 share order (10 contracts) 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.
This is the appropriate way to think of using options.
Instead of buying $100,000 worth of stock I will buy the option equivalent.
What most people do is they use the leverage of options to over leverage themselves. They may only have $5,000 in their account and the place all of it on one trade. Then when the trades goes bad they lost everything.
Money management is your key to overcoming the ROI leverage risks associated with option trades.
Now let’s talk about the ugly truth about options…
Options 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 draw down, but we also have to use time management to manage the calendar.
My general rule is to sell the option 2 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 2 weeks are when the time decay curve accelerates and it makes it very difficult to make money buying options.
This is the “ugly” part of options. It’s not unmanageable 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.
The reality is “there’s no free lunch”. Option buying has its advantages and option selling has its advantages. Neither is perfect in every scenario and I also don’t think either one is right for all people. Individuals have to decide what works for them.
Stock options are a powerful tool available to traders. When deployed properly they can provide great income opportunities. As an option buyer, the odds are somewhat set against you, however, the use of the option will ultimately 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 direction of the trade, 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. I, for one, prefer to trade with options in 99% of the circumstances. But just because I prefer to use the option it does not mean it’s a better choice. Each trader is individualistic and you need to fully understand the risks of options as well as the benefits before entering trades with them.