Investing in a stock generally requires you to pay the share price , multiplied by the number of shares bought. If you wanted 100 shares of Google ( GOOG), it would cost around $57,600 (100 * $576). However, there is an alternative method that requires less capital: options. This is done by using "in the money" call options that mimic the movement of the stock. The deeper in the money the call option - meaning the closer the delta is to 1- the better the option price will track the stock’s movement. ( To learn more about options see our Options Basics Tutorial.)
There are 12 exchanges in the US that allow investors to trade options, with Chicago Board of Options Exchange (CBOE) being the largest.
* Figure 1
If you have a short-term investment horizon, you could probably take a call option expiring on October 18 of 2014 as shown in the table above. Each option represents 100 shares of Google. The strike price is the price at which you have the right but not the obligation to buy the stock. The price you pay to have this option is the premium price or the last price. As the strike price decreases, the call option is deeper in the money and the premium also increases. The volume, i.e. the number of option contracts traded, affects the bid-ask spread: the higher the volume the lower the bid-ask spread. The lower the bid-ask spread, the more savings on transaction costs for the investor.
Say you buy the 520 Strike Google option at the ask price of $61.2, the breakeven price then becomes $581.2. On September 3 of 2014, the stock was trading at around $575. If the stock stays at $575 until October 18 of 2014, the option price should decline to $55 as the strike price ($520) plus the premium ($55) would then equal the stock price ($575) , thus cancelling any arbitrage opportunity.
Since the delta of the option is 1, any change in the stock price should move the option price by the same amount. For example, if the stock price moves to $600 at expiry, the option price would become $80 ($600-$520), for a gain of $18.8, which is $6.2 less than the $25 gain for the stock. The $6.2 represents the time value of the option which would decay eventually to zero at expiry.
Options Provide Buying Opportunity & Protection
Another benefit of investing in Google or any other company using options is the protection an option carries if the stock falls sharply. The fact that you don't own the stock but only the option to buy the stock at a certain price protects you if the stock takes a plunge. This is because you will only lose the premium paid for the option instead of the actual value of the stock. Say you hold 100 shares of Google and they fall sharply from $575 to $100. This represents a loss of $47,500. However if you own a call option of 100 shares of Google you will only lose the premium paid. If you paid $61.2 per share for a call option of 100 shares of Google, you will only lose $6,120 versus $47,500.
Longer-term options are relatively more illiquid than shorter-term options and therefore the transaction costs in the form of bid-ask spread would be higher. Figure 2 shows the number of trades for call options expiring in June 2016 are less than in the March 2015 expiry, which is less than the October 2014 expiry. Therefore, it becomes quite expensive and difficult to invest in a stock using options for the long term. One alternative is to roll over the options at each expiry, but this would also increase transaction costs in the form of higher brokerage fees.
* Figure 2
For some companies and other securities, there are also mini-options for which the underlying is 10 shares instead of 100. This is useful for smaller investors and for hedging odd lots of a particular stock, i.e. not in multiples of 100. Unfortunately, the volume in these options is not high and mini-options are not as common as regular options.
The Bottom Line
Using options is a cost effective way to gain exposure to a stock without risking a lot of capital and still being protected on the downside. One of the main drawbacks is the liquidity of the option contract itself. If you are an investor interested in investing in companies with a high stock price (i.e Amazon (AMZN), Tesla (TSLA) or Google) without tying up too much capital, options might be the right answer for you.