Are Stock Options Really Riskier than Stock?


Note from the author:  This is the first of a series of articles I plan to write on investing in options.  This article is about buying Call Options primarily rather than investing in the actual underlying stock.

The Securities and Exchange Commission (SEC) really wants you to believe that Stock Options are always riskier than stocks – even though this is not necessarily true.  As a matter of fact, before you can even be approved for options trading by your broker you are supposed to read a 183 page booklet The Character and Risks of Standardized Options.  Most people don’t read it … and most do lose money.

But the question is … are they really riskier than outright stock ownership?  The short answer is some are and some are not.

You see options investing can be used for Leverage, Hedging, Income, and Superior Appreciation.  There are two kinds of options:  (1) A Call Option, and (2) A Put Option.  The call option is to be used when you believe the price of the stock is going up (a bullish stance) and a put option is to be used when you believe the price of the stock is going down.  Either of these options can be bought or sold.  If you buy an option (Call or Put) you pay a premium.  If you sell an option (Call or Put) you are getting the premium.  So for each option buyer or seller there is always someone on the other side of the trade.

Premiums are stated in terms of Price per share.  Options are sold in Contracts with each contract normally equal to 100 shares of the underlying stock.  While options can also be sold or purchased on an index (such as the Dow Jones Industrial Average or the S&P 500) as well as Exchange Traded Funds (ETFs) this article is focused on Stock Options.

With every option there is also a “strike price.”  This is the price at which the contract will be initiated.  This strike price can be “In the Money (ITM)”, “At the Money (ATM),” or “Out of the Money (OTM)”  The more In the Money the higher the premium and the more Out of the Money the lower the premium.  Naturally, the higher the premium (on the buy side) the lower the potential return and vice-versa the lower the premium the higher the potential return.  If you are investing for income (e.g. selling options) the more in the money … the higher the premium and the higher your potential return.  The more out of the money the lower the premium and the less your potential return.

Options can be purchased or sold individually or grouped together into various spreads to lower overall risk.  Again this is usually done on both the buy and sell side.

The one thing that is critical to understand is this:  A buyer of an option (call or put) has a right to buy or sell (depending on the side he/she is on).  The seller of an option (call or put) has a requirement to buy or sell (again depending on the side he/she is on).

When you look at options premiums you will likely see two quotes … a bid and a ask price.  The bid is he price the options buyers and sellers operate at.  The ask price is the price the market maker operates at.  The Ask price will always be higher than the Bid price – that’s how the market maker makes his money.  Sometime the spread between the bid and ask can be great and sometimes it can be as small as a penny.  It usually depends on the volume of the options being traded.

Today I am going to work with Call options only.  Specifically the buying side of call options.  In another article we will visit the sell side of Call options and discuss the risky way and the most conservative way of doing them.

An example using Apple Computer (AAPL):

Today 09/24/2018 this stock closed at $220.79.  It was up $3.13 or 1.44% from the previous days closing price.  This means that if you wanted to purchase 100 shares of AAPL at today’s closing price you would pay $22,079 not including commissions.

AAPL 09-24-2018

As the chart above shows, AAPL has had a nice increase over the past year from about $150.55 to $220.79.  Even over the past three months (red line) this upward trend appears to be continuing from about $182.17 to $220.79.  Over 1 year the growth rate has been 46.66% and over the past three months the growth rate has been 21.20%.

However, to get these returns you’d have to invest $22,079 today and hope the uptrend continues since we cannot go back in time.  Someone once said that “life can be looked at backwards … but it can only be lived forwards.”  The stock market is the same.  We can view it in the rear view mirror with 20/20 hindsight … but we must invest in it with no knowledge as to what tomorrow will bring.

How else could you have control over AAPL stock without investing such a large sum?

ANSWER:  By using stock options.  Allow me to give you an example.

On August 7th of this year (2018) I took a look at Apple (AAPL).  At the time the price was around $208 per share.  The stock opened that day at $209.32 and went as high as $209.50 and as low as $206.76, but closed at $207.11.  Let’s assume that I’d purchased 200 shares of the stock at $208.00.  I would have invested a total of $41,600.  However, with money tied up in other investments … I just did not have $41,600.  If I would have had it and purchased the 200 shares then by the close of business today with the stock at $220.79 I’d be up by $12.79 per share or $2,558 over all.  By dividing $2,558 by the investment amount of $41,600 that would have been a gain of about 6.15% – which is not bad for a period of just 33 market days.

Like I said … I did not have the $41,600 necessary to invest in the stock.  However, I did have about $3,500 that I could invest at the time.  Here’s what I did:

I went to my Charles Schwab account and purchased 2 Call Contracts on the stock.  Since the stock was trading at about $208 I purchased contracts with a strike price as close as I could get ATM (at the money).  I purchased the $210 calls.  I also used a expiration date of June 21, 2019.  For those that don’t know … normal expiration is the Friday before the 3rd Saturday of the month.  What this means is that if the contracts have not been exercised by then … they will expire worthless and the holder of the contracts will have received $0.00 after spending money to purchase them.  If they happen to expire in the money (in other words should have been exercised and were not) the Options Clearing Corporation and the Chicago Board of Options Exchange will randomly assign then (or exercise them) for you.

These contracts allow me, in a way, to control 200 shares of Apple Stock for a period of time.  Now when it comes to options, TIME can certainly work against you.  An option is like an Ice Cube.  The day you buy it … it starts to melt.

ice cubeIf you have ever watched an ice cube melt you will notice that it melts slowly at first but the longer it is left out of the freezer the faster it melts.  Options use Greek terminology and I am not going to teach it all here … but “Theta” is the rate at which an option will lose value (or melt) each day it is outstanding.  Take a look at the illustration below:

Option Time Decay

This is an example of a 180 day option and you can see that it clearly loses 50% of it’s value in the last 45 days of time before expiration.  You must understand that this is the Time Value portion of the premium that was paid or received.  There is generally two parts to an option premium … a Time Value and an Intrinsic Value.  For example, in the illustration above the option started with about $0.65 of time value.  Had a person paid, let’s say a dollar for the option then it would have had $0.35 of Intrinsic Value and $0.65 of time value.  The intrinsic value changes based on the price of the underlying stock while the time value only decays over time.

Even if I had the $41,600 to invest in the Apple stock, I would have likely purchased options anyhow.  But why, knowing that the time value of the option is only going to decay the longer I hold on to it?  Here’s why!

First notice that I purchased an option on August 7, 2018 that does not expire for about 10 months from that date (it has a June 2019 expiration date).  This gives me plenty of time to let the stock work to increase my Intrinsic Value of the option.  Now, you cannot always purchase options 10, 12 or 18 months out on all stocks (though most larger companies allow it if they allow options at all), but I highly recommend it when you are buying.

On the flip side, when you are selling options … then go short-term.  I really like the time frame of 21 to 45 days.  This will net you some decent premiums and the “fools that buy short-term options” lose less than those of us that go long-term … but they lose more frequently. The seller of options 21 to 45 days out (when options lose the greatest values) are like “casinos” taking money from “stupid gamblers.”

Let’s get back to my option and why I would rather consider options on companies that allow them than consider the stock.  And, remember, not all companies allow options.  Out of more than 10,000 publicly traded companies in America, only about 3,500 or so have options available.

As I said, I purchased 2 Call Contracts on AAPL.  The premium I paid to do this was $16.7714 per share at a time when the stock was selling for $208 per share.  So for 2 contracts (each being worth 100 shares) I paid a total of $3,354.28 rather than $41,600 it would have cost to invest in the stock.

The price of my options as of this writing is $26.425 per share.  This means I could sell these options contracts to another options buyer for a grand total of $5,285.00 and net a profit in 33 days of $1,930.72.  If you are calculating that … it is a Return on Investment of 57.56% as compared to the measly return of 6.15% that I would have had if I had purchased the stock back on August 7th.

At this point as the options buyer I do have some options.

  1.  I could force the seller of the options to sell me the stock at a price of $210 per share (my strike price) while the stock is trading at almost $221 per share.  but why would I do that.  By the time I paid the $210 per share plus the options premium I paid of $16.77 per share … I would have spent $226.77 per share.  You see, I would not even consider this until the stock goes much higher than $226 per share.
  2. I can sell the options now and collect my gains and move on to another adventure.
  3. I could split my options, sell one and collect my gain and hold the other one.
  4. I can hold my options and see if AAPL goes up more in the future.  If it does go up … so will my option price.  This works off another Greek term “DELTA.”  Here’s how Delta works:

Based on the Black-Scholes formula that calculates a fair (theoretical) market value for the option. The Delta is a measure of the sensitivity the option value has to changes in the underlying (index/stock) price.

For every dollar of movement in stock price, the price of the option can be expected to move by delta points. If the delta is 0.5 then a one point change in the stock price will change the option price by $0.50.

Deep out-of-the-money (OTM) options will have a delta which approximates 0. Deep in-the-money (ITM) options will have a delta which approximates 1.00. At-the-money (ATM) options have delta near 0.5.

In case you are wondering, the DELTA of my option at this time is $0.6789 meaning that for each $1.00 increase in AAPL stock my option should increase by about $0.68.  And, this is how you offset the Greek that melts away at your option “Theta.”

The point is options buyers have options while options sellers have requirements.

Quite naturally, if AAPL stock were to go in the dumper (as Archie Bunker used to say) it would not take long for the option to go to $0.00.  So, if I could lose 100% of what I put into an option why would I say it is more conservative or less risky than owning the stock outright?

Let’s look at it:

My first question when I made this investment (or any investment) is, “Jerry Can you afford to lose it all?”  If the answer is No … I get skeptical about investing.  Not saying I don’t invest … I’ve made some pretty dumb ones over my lifetime … but I do think twice now.

Second I also consider this.  If I invested $41,600 in Apple Stock and Apple has a bad earnings report and the stock drops by 10% … would it hurt me?  I mean after all my investment would have gone from $41,600 down by $4,160 to $37,440.  If I lose 100% of my option $3,354.28 that is still far less than losing 10% of the stock price ($4,160).

Here’s another thing I try to do and I recommend that you all consider this.  Never invest more than 2% of your portfolio into any one holding.  If you will stick to this rule you will be able to keep 50 holdings in your portfolio and I’d almost be willing to bet you that unless you are asleep 24/7 you are not going to lose on all 50 holdings.  The winners should more than make up for the losers.

Here’s a summary for you (when buying options):

Consider options on expensive stock rather than the expensive stock.

If buying … make sure expiration is 6 months or longer away until you really learn what you are doing.  The longer the term the higher the premium … but it gives time a chance to work in your favor.

Never invest more than you can afford to lose.

Never invest more than 2% of your options portfolio into any one holding.

Make sure you “close out” your options before the 45 day period before expiration begins.  Remember 50% is lost in the last 45 days.

If you option hits 100% return rather quickly (e.g. 3 months or less) close out 1/2 your holdings to get your money back and let the remainder run as long as the stock is still going up that the option covers.

Don’t get greedy.  Set a profit target and stick with it.  Its been proven time and time again that taking smaller profits more quickly will make you more in the long run because you can trade more.

Finally, should you have any questions, please feel free to reach out to me.

Have a great time investing,

Jerry Nix

 

One thought on “Are Stock Options Really Riskier than Stock?

  1. Pingback: Buying Options Lesson #1 – FreeWaveMaker.com

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