Options provide a great way for traders and investors to realize the gain on equity movements without purchasing the underlying securities, yet only a small fraction of people utilize them in their own portfolios. Many traders and investors instead discount them as too complex and risky, when in many cases they can provide a superior risk/reward ratio over simply purchasing the underlying equity.

Tutorial: Options Basics

This article will explore these situations and detail how both traders and investors can use options as equity substitutes in order to multiply their portfolio gains while minimizing additional risk. (To brush up on your options skills, see Options Basics Tutorial and Reducing Risk With Options.)

Options for the Investor
Options can provide investors with a great way to multiply profit while reducing risk in certain situations. Many tend to ignore options, however, simply because their value decays with time - a fact which seems to contradict the very principles of investing! There are, however, several instances where utilizing options instead of equity can substantially increase risk/reward over the long-term.

Long-Term Equity Anticipation Options (LEAPS)
LEAPS are long-term stock or index options that expire after more than nine months and sometimes as long as two years. They were first introduced by the Chicago Board of Trade in 1990 to enable investors to use options in their portfolios.

Let's quickly compare how purchasing LEAPS instead of stock can be beneficial for investors:

Suppose an investor with a $10,000 portfolio wishes to purchase 100 shares of XYZ in January 2007, which were trading at $50 per share at the time the trade was placed. The investor has the following choices: purchase the stock outright, utilize 50% margin at a rate of 9% to purchase on margin, or purchase a LEAPS call expiring in Jan. 2008 with a strike price of $40 paying an option premium of $12.25. Let\'s then assume the stock rises 20% to $60 per share after one year.
-- Using Stock Using Stock w/Margin Using Leaps
Cash Down $5,000 $2,500 $1,325
Borrow $0 $2,500 $0
Carry Cost* $0 $225 (9% over 1yr) $220 (time premium)
Less Dividends -$50 -$50 $0
Net Carry Cost -$50 $175 $220
Risk $5,000 $5,000 $1,325
Net Profit 21% 33% 59%

* Carry costs are out of pocket expenses that investors pay on an investment, such as interest and incidental expenses.

This example, albeit simplistic, shows that while the carry cost and break-even point associated with LEAPS may be slightly higher, the overall risk is substantially lower. Now, the obvious risk is that LEAPS can expire worthless while stock always retains some of its value; however, the risk of LEAPS expiring worthless can be mitigated by purchasing them deep in the money. The further in the money the LEAPS are, the less likely that the price will move below the strike price causing them to expire worthless. This situation should be evaluated on a case-by-case basis.

LEAPS are also useful when betting on smaller price movements in safer stocks or indexes. For example, a 5% annual return on a normal stock may not seem like much for a traditional stock investor, but LEAPS can multiply that number to make it worthwhile. They are very popular for "expensive" stocks that tend to move less on a percentage basis than others.

In the end, LEAPS can occasionally provide investors with a more profitable and "safer" way to bet on long-term price movements without putting down all the capital necessary for purchasing the underlying stock. While they are certainly not perfect for every portfolio or situation, there are cases in which they can be effectively used to enhance returns while taking on minimal additional risk.

Options for the Trader
Options can also provide traders with an excellent way to multiply their profit while reducing their risk - and in some cases even reversing it! As an added bonus, options also take some of the emotion out of trades since there is less capital at stake and a more defined strategy.

Technical traders typically focus on either profiting from trading ranges or breakouts/breakdowns from these trading ranges. So, here are some strategies where options can be effectively used as equity substitutes in these situations:

Breakout Traders
Breakout traders take a substantial risk when they purchase a stock since these technical patterns are designed to predict impending volatility. The hope is that they can correctly predict the direction often enough to account for the increased risk. But what if there was a way to not only benefit more from a breakout in the direction you predict, but also offer protection in case you're wrong? (To learn more about breakouts, see Spotting Breakouts As Easy As ACD and Trading Failed Breaks.)

Backspreads offer the best solution for breakout traders by limiting potential losses while maintaining unlimited profit potential. In fact, if the price moves down enough, traders can even make a small profit on the trade. Keep in mind, however, that the potential loss lies in situations where the stock doesn't make a move in either direction - so make sure the breakout pattern is accurate. (To learn more about using backspreads to profit, see Backspreads: Good News for Breakout Traders.)

Alternatively, breakout traders can use simple call or put options to straight bet without hedging. The key thing to remember when buying short-term options is to buy more time than you think you'll ever need! While you may predict a breakout over the next week, always allow some extra time for it to occur.

Trend Traders
Trend traders also take a risk when they purchase a stock since they are relying on the stock's trend to remain strong over the long-term. Any slowing of the trend can result in lost opportunity costs, while any reversal can turn a profit into a loss. But what if there was a way to multiply your gains on the upside while limiting your downside exposure? (To learn more, see Trading Trend Or Range? )

One solution is the use of LEAPS. Long-term trend traders can benefit through the use of LEAPS in the same way that long-term investors do. These should only be used when traders are confident in the trend, however, as they can expire worthless if they drop below the strike price.

A surrogate covered call write is another solution for shorter-term trend traders who are neutral to bullish. Covered call writing enables traders to profit off of the premium, which is retained while the stock rises to the option's strike price. The obvious downside is a situation where the stock price declines, where traders are then stuck with a losing stock and a small premium. To solve this, the strategy uses LEAPS in lieu of actual stock in a covered call write in order to both better leverage your money and reduce risk. (For more information about this strategy, see Using LEAPs in a Covered Call Write.)

Conclusion
Options can be the perfect substitute for equity in some cases, enabling traders and investors to multiply their returns and diversify their risks. They are certainly not perfect in every situation, however, and should be researched carefully before being used in practice.

Related Articles
  1. Chart Advisor

    3 Ways to Trade the Rising Volatility

    With volatility increasing in the markets, many are turning to these three volatility-capturing exchange-traded products.
  2. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  3. Chart Advisor

    Gold Struggles to Climb Higher and May Fall Soon

    Traders will be watching the price of gold over the coming weeks. We'll take a look at how a couple major moving averages are suggesting that the next move could be lower.
  4. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
  5. Options & Futures

    Understanding How Dividends Affect Option Prices

    Learn how the distribution of dividends on stocks impacts the price of call and put options, and understand how the ex-dividend date affects options.
  6. Home & Auto

    Avoiding the 5 Most Common Rent-to-Own Mistakes

    Pitfalls that a prospective tenant-buyer could encounter on the road to purchase – and how not to stumble into them.
  7. Chart Advisor

    4 Stocks Still Flashing Buy Signals

    In the midst of volatility and a big market sell-off last week, these stocks are flashing buy signals.
  8. Home & Auto

    Renting vs. Owning: Which is Better for You?

    Despite the conventional wisdom, renting might make more financial sense than you think.
  9. Technical Indicators

    Understanding Trend Analysis

    Trend analysis is the use of past performance to predict future price movement of a security.
  10. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Normal Profit

    An economic condition occurring when the difference between a ...
  4. Theta

    A measure of the rate of decline in the value of an option due ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Security

    A financial instrument that represents an ownership position ...
RELATED FAQS
  1. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  2. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  3. What are common delta hedging strategies?

    The term delta refers to the change in price of an underlying stock or exchange-traded fund (ETF) as compared to the corresponding ... Read Full Answer >>
  4. How do I determine the breakeven point for a short put?

    The breakeven point for a short put is the strike price of the option minus the premium. Selling puts is a way for traders ... Read Full Answer >>
  5. What options strategies are best suited for investing in the retail sector?

    Retail is a broad sector whose seven discrete segments all exhibit greater volatility than the broader market. The sector ... Read Full Answer >>
  6. What techniques are most useful for hedging exposure to the telecommunications sector?

    A couple of option strategies can be used to hedge exposure to the telecommunications sector. Certain option strategies can ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!