Should I be buying stocks or options?

What are the pros and cons of buying options vs. buying the underlying stock?

Financial Planning, Stocks
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April 2017
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Great question. As our firm's Chief Derivatives trader, I can tell you that there are pros and cons to both approaches, which I will cover momentarily, but bear with me for a quick second while I debunk a myth that we hear traders and even advisors use ALL THE TIME.

The Myth, "90% of all options expire worthless." This is nonsense. First off, roughly 60% of all options contracts are closed prior to expiration. Second, roughly 10% of all options contracts are exercised, therefore that leaves only 30% left that could expire worthless. It's important to understand these types of things so that you don't have an irrational fear of this type of trading product. Alright, on to your question.

Ultimately, what you choose to do should be based on what your goal for that particular position is. Do you want to own the shares indefinitely or for a finite period of time? Are you trying to reduce your risk going into a binary event like earnings? It is worth noting that since options do have an expiration date, your holding period will help you make the correct choice for the type of trade structure you need to use. Finally, it is important to understand that options do have different associated risks that are not inherently found in stocks, so please do some homework before you start trading. Now all of that being said, options when used appropriately, can actually help to reduce your risk in a given trade. I'll use an example below, but please realize that this is not a recommendation, merely an example. I'm going to use real numbers from a real stock, but I won't name the company as that isn't important, rather your understanding of the trade structure is what matters.

Let's say you wanted to buy 100 shares of a company that is currently trading at $142 per share. Not accounting for commissions, this would cost you $14,200 and while there are ways to mitigate risk with various stop-losses for all practical purposes, your max loss is now $14,200. This same trade done with options might look something like this. You could buy a call at $140 for roughly $5.30 per share. One quick note, most options contracts are standardized and based on 100 share lots, therefore, you would need to multiply $5.30 x 100 to determine your cost which in this case would be $530. This $530 represents your max loss. So just looking at the numbers, would you rather have the potential for a max loss of $14,200 or $530? Also, accounting for the fact that at the time of the trade our stock is priced at $142 per share and you bought the $140 strike call. This means that you already have $2 of intrinsic value. If we assume you hold the option to expiration, even if your stock doesn't move and finishes at $142, you would only lose $3.30 per share, not the full $5.30. Now in order for this trade to make money, you need the underlying stock to trade higher than $145.30 by expiration. Based on the current statistics. you have a roughly 40% cahance of this occurring by that particular options expiration date.

Now please realize that there are different ways to structure a similar trade that would have a higher probability of success by layering in other options positions, but hopefully, this simple example helps lay out some of the pros and cons of using options.

If you are new to options trading, please consider using a brokerage firm like TD Ameritrade that gives you access to a "Paper Trading" account. This way, you can learn to trade in a simulated environment without risking real money. They can always give you more virtual money, but they are less likely to give you back real money that you may have lost. =)

Please feel free to reach out to me with any additional questions or follow me on Facebook or Instagram for additional updates as well as our upcoming blog posts and videos.

John Fowler, CFP®

April 2017
April 2017
April 2017
April 2017