Stock Options Vs Buying Stock

If you are familiar with the basics of buying stock, you might be wondering why an average investor would ever choose to buy stock options instead of simply buying the underlying security. The answer, in a word, is leverage (but don’t forget, leverage cuts both ways). If you are correct about a move in the stock’s price, you stand to gain a lot more than if you simply bought the stock. Some investment experts advocate putting a very small percentage of your investment funds, maybe 5%, into leveraged investments such as options as part of a strategy to enhance your overall portfolio. Do this only if you understand them thoroughly though! Here’s a quick options explanation:

With options you’re buying the right to purchase a stock at a given price at a given point in the future. If it’s November and ABC stock is at 22 and you buy a call option with an expiration in January, that gives you the right to buy 100 shares of ABC at $25 a share. You might pay a premium of, let’s say, $100 for this right. If by January the stock moves to let’s $27 per share, the right to buy it at $25 would be worth at least $200, as you could buy 100 shares at $25 and resell it immediately at $27 for a $200 profit. To extend the example, at 29 our option would be worth at least $400. You can see the power of leverage here- assuming you get the move you want in the stock!

While a quick upward move in the stock price even to, say, 24 would increase the value of your right to buy (your “option”), at which point you might choose to sell at say $125, waiting for a move in the stock to rise above the so-called strike price (25 in this case) so the option has intrinsic value, is often (not always) the real goal of an options buyer.

In our example, if after hitting 24 the stock declined and never came back to 25, the option expires worthless. You’d lose your $100 investment, and you might regret not taking your quick profit when the value of your option was at $125. Once the stock is trading in the money however, ie above the strike price, we have some intrinsic value to rely on.

Just to drive home the leverage illustration, simply buying 100 shares at 22 will cost you $2200, and a move even to 29 would represent approximately a 30% gain. In two months this is very, very good, but it’s nowhere close to the 400%+ gain you’d experience in our example.

Getting stock options or share options explained to you and understanding them very well doesn’t mean that you will consistently have good results in your trading. In fact, you probably won’t, which is why I recommend index funds.  But if you’d like to stick your toe into the world of options trading I’d strongly suggests you paper trade for a while, to learn and become acquainted with the risk and return characteristics of stock options.