Should I be buying stocks or options?
What are the pros and cons of buying options vs. buying the underlying stock?
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. =)
John Fowler, CFP®
First, options are only beneficial if they can be exercised. If the options expire without being exercised, you’ve lost money. And depending on how volatile the underlying security is, and how big the option purchase is, you could be out a substantial amount of money. Whether you buy an option or the underlying security, there is always the option of losing your investment. But when you own the underlying security, the only way to theoretically lose part or all of your investment is if the price of the security falls below the price you paid for it. If the purchase price of the stock stays flat, or increases, then of course, your investment is still in tack. With an option, there are a few more ways to lose your investment. If you buy an option with the belief that the price will rise and it stays flat, declines, or increases, but not over the strike price of the option, you’ve lost your investment.
The pros with regards to an option purchase is leverage. A small initial investment allows you to control a substantial amount of value. And if the option moves above the option strike price, the return on your investment will be far greater than if you bought the underlying security outright. Individuals who are new to trading options should always remember that option trading is a “zero sum” game. For every winner, there will be a loser.
The answer to your question is, stocks, probably.
There are several different kinds of options, but I'll assume you mean call options because you're comparing options to stock ownership. If your time horizon is long, then stocks would be better. If you don't understand the decaying value of an option, stocks would be better. And if you're not gambling with a small dollar amount looking to make large returns in a short amount of time, stocks would be better.
Like another advisor said, if you have to ask which is correct for you, I would urge you to avoid options. In any event, the best solution is to start educating yourself on each.
Adam Harding, CFP
Options can be good for position trading and risk management. Choosing the right strategy to your advantage is important. Picking the proper options strategy to use depends on your market opinion and what your goal is.
An option gives its holder the right, but not the obligation, to buy or sell the underlying asset at a specified price on or before its expiration date. There are two types of options: a call, which gives the holder the right to buy the option, and a put, which gives its holder the right to sell the option. A call is in-the-money when its strike price (the price at which a contract can be exercised) is less than the underlying price, at-the-money when the strike price equals the price of the underlying and out-of-the-money when the strike price is greater than the underlying. The reverse is true for puts. When you buy an option, your level of loss is limited to the option’s price referred to as premium. When you sell a naked option, your risk of loss is theoretically unlimited.
There are many pros and cons to consider. The time value with options or their expiration versus a stock with no expiration. The amount of funds you have to invest since you can leverage yourself by buying the option, not to mention the multitudes of differing options strategies. For example, a covered call writing strategy would allow you to buy the stock and write (or sell) calls against your position in order to receive income or a premium from the option. Holding a long position on the stock and generating income from the option premium.
If you are a novice options investor, it would be wise to find a financial advisor that specializes in options in order to start slow and learn the complexities of option trading.
Assuming that you are referring to stock options, you can buy either call options or put options. Buying the underlying stock and avoiding buying it on margin allows you to participate in the upward appreciation of the stock price and any dividend that the company is paying to its shareholders. No one or no instance can force you to liquidate the stock before you are ready. If the company has a history of good management decisions, consistently pays dividends, and is in strong financial shape, I consider its purchase to be an "investment".
I consider buying a call option on the same underlying stock to be a "speculation" or a form of gambling. Buying a call option allows you to participate in the upward price action of the underlying stock and profit from it, so long as the stock price moves up within the time frame of the option (i.e.- 3-6-9 months before it expires worthless). The advantage over buying the stock is the financial leverage you get (paying less for the option than shares of the stock). That leverage would allow you to earn a higher rate of return from the option than you would receive by owning shares of the underlying stock.
The disadvantage to buying the call options is that you have to be right about two things, the stock price going up and the stock doing so within the 3-6-9 months period before the option expires worthless. It's tougher to be right about both of those things, because it involves the issue of timing. You could "exercise" the option to buy the underlying stock at the specified option price. If the stock wasn't appreciating, that wouldn't be attractive either.
It's important to ask yourself up front "Am I investing or am I speculating here?" Experience has taught me that the power of compounded interest will allow you to get rich slowly but more surely, without resorting to gambling on an unsure thing.