Are options better than stock? That is a question that I am asked often. In this live example I hope to show you why I like options better than stock.
First in researching options I follow the same rules I’d follow if purchasing stock.
Rule 1: does the chart of the stock show the price going up from the lower left hand corner of the graph to the upper right hand corner in a rather smooth line (all stocks will have short-term ups and downs), but what I’m looking for is a longer-term trend up?
Rule 2: is the three main Simple Moving Averages moving up in price, again from the lower left to the upper right – and – is the 50 day SMA above the 200 day SMA … is the 20 day SMA above the 50 day SMA and is the price of the stock above the 20 day SMA?
Rule 3: does the stock look like it can continue an uptrend at least through the expiration date of the option? I will normally purchase options that are from 6 months to 12 months out in time to be able to put “time on my side.”
Make sure time is not against you when buying options.
As an options investor the one thing you can learn quite quickly is that the greek THETA can destroy the value of an option premium rather quickly if given the chance over the last few days of an options life. For example, look at the graphic below:
Notice on this 120 day option (4 months) the fastest time decay is in the last 30 days. Now, people can make money SELLING options that have a short period till expiration which can be explained in this simple video. But likely as not if BUYING the option they will almost always lose money if the time for the option to expire is less than 45 days out. So why would they purchase an option with a short-term expiration?
THE SHORTER THE TERM THE LESS THE PREMIUM THEY WILL HAVE TO PAY!
In other words they are looking to make a lot of money with very few pennies. As I said, I like to look 6 to 12 months out to purchase an option. I will spend more money on the option but will put time on my side and give the underlying stock time to work before I must close out the option play.
Case in point
Take a look at Freeport-McMoran Inc. (FCX) as one example from my options portfolio (and I have about 30 examples at the present time that I could have used).
In the chart below the Yellow Vertical Line shows the date I purchased the option (rather than the stock).
- Was the price moving from lower left to upper right? Yes
- Was the three Simple Moving Averages (20 day, 50 day and 200 day) moving from lower left to upper right? Yes
- Was the 50 day MA above the 200 day MA, was the 20 day MA above the 50 day MA, and was the price of the stock above the 20 day MA? Yes
- Can the stock continue to climb for the next 6 to 12 months? Yes, I believe it can since Freeport-McMoran is a leading mining company of copper and gold. As infrastructure continues improving in the U. S. we are going to need more copper. As the dollar continues to devalue in the U. S. gold will likely continue to rise and shortages could cause more mining for the “yellow metal.”
So on October 22, 2020 I purchased 10 contracts of FCX with a strike price of $19 per share and an expiration of May 21, 2021. That is a time frame of about 7 months (so it falls within my 6 to 12 month time frame).
When I say 10 contracts that means that I have paid for the right to purchase 1,000 shares (100 shares per contract) of FCX at anytime before the option expires on 05/21/2021. The price I have agreed to pay for these shares is $19.00 per share. On the day I did this the stock had opened at $17.55 per share. It hit a high that day of $18.40 per share and it hit a low of $17.30 per share. It ultimately closed at $18.35 per share.
By my willingness to pay $19 per share I was buying the call “At the Money” (or as close to ATM as possible). To do this I had to pay $2.51 per share ($251 per contract) which equates to a total of $2,510 that went out of my account for the options contracts. Now I could have purchased 1,000 shares of the stock at a total cost of $19,000 but I chose to lay out a fraction of that amount (about 13%) to be able to purchase the stock later at that price. In options circles laying out 13% of a stock price to control a number of shares in the stock is known as LEVERAGE.
If I would have purchased the stock and it ultimately went to $0.00 (which could happen) what is my risk? Correct, $19,000.
By purchasing the options should the stock go to $0.00 what is my risk? Again correct, $2,510.
A MAJOR RULE FOR SUCCESSFUL INVESTING … LOSE AS LITTLE AS POSSIBLE!
What is my upside potential if I purchased the stock? Unlimited.
What is my upside potential for purchasing the option? Again Unlimited.
Let’s look at the chart now:
Now as you can see by the chart, the stock is trading at $24.70. This means that I could purchase the stock for $19,000 and turn around and sell it for $24,700. Would this net me a gain of $5,700 or 30% — not hardly. You see, I would have to include the cost of my option to come up with a gain. So, if we add $2,510 (the cost of the option) to the purchase price of the stock ($19,000) we would have a total cost of $21,510. If I turned around and sold the stock for $24,700 I would net a gain of $3,190 or about 14.83%. Now that is not a bad gain in a period of just under 2 months. Based on a holding period of about 1 month and 3 weeks that would be an annualized gain of about 110.17% (assuming 14.88% divided by 7 weeks and multiplied by 52 weeks). Not shabby.
But let’s look closer at the option.
Today the option premium is trading at about $6.64. That means the value of all my contracts are now worth $6,649.87 if I were to sell them now. Therefore as you see on the chart I already have a gain in the options of about $4,139.87. This means in the 7 weeks or so that I have held these contracts the value has grown by a total of 164.94%. Now if we annualize that number over a 52 week period that would be an annualized gain of nothing less than 1,224.23%. Yes, I know that I cannot hold these options for 52 weeks as they are set to expire in the next 156 days. However, I could always buy more options then, and duplicate the returns.
That being said, this is the plan:
When I purchase an option I always use a bracket order to close them out. I actually call it a Profit-Loss Locker order. Once the option is in my account I immediately set two sell orders. One states that if my option grows by 200% to sell it. The other says that if my option falls by 50% to sell it. The 200% is based on the premium I paid for the option while the 50% is a Trailing 50% of the current price of the option as long as the current price is above the previous price. In other words, the 50% trail will follow the option bid price up but not down.
With this Profit-Loss Locker this is the current “Trigger Prices” at my brokerage firm.
- On the upside … sell if my price hits $7.53
- On the downside … sell if my price hits $3.35
This is what it actually looks like when I set it …
What this means is if the option should hit a price of $3.32 or a price of $7.53 it will be sold at the next available bid/market price. This does not guarantee a price but rather an action that will lead to a price. The neat thing is that I don’t even have to be at the computer to do this. The computer will do it for me even if I am on the golf course or riding my motorcycle.
With Profit-Loss Lockers you also have options!
You can always go in and reset you Profit-Locker options if things are going in your favor (or if they are not). Today while writing this article I decided to do just that and have changed it to the following:
Notice that I have changed it from an average cost to the current bid price. This has changed my trigger price on the upside (200%) from a price of $7.53 to a price of $20.10 for the option. The 50% trail will be about $3.35 based on the current bid price. As the bid price grows, for example to $10 the trigger price on the 50% trailing stop will also grow to $5.00. Again, this trailing stop loss follows the bid price up and not down. So, it it hits $10 per share and falls back to $9 per share my stop order remains at $5.
By the way, if the option got stopped out today on the trailing stop … I’d still make money. It would sell for close to $3.35 per share and I paid $2.51 per share.
So, let me end by asking you — Are options better than stocks? Only you can decide for yourself, but for many of you – you may want to consider adding a few options to your stock investments. The best way to learn options is to actually invest into them.
Let me know if you have any questions.