Posted by: Tyson Heyn | August 25, 2009

Why stock options?

Earlier this year, I decided to investigate stock options as a trading/investing strategy.  (I’ll get into the difference between trading and investing at a later date.) 

The reason was simple–while I had survived the steep market drop of Sep. 2008 – Mar. 2009 by mainly getting out of equities and into corporate bonds, I knew that there had to be a better way to manage risk and improve profitability.  I didn’t know what capabilities options offered, but I decided that it was worth the effort to educate myself.

Surprisingly, it turned out that options are much more appealing investment vehicle to me than stocks.  A lot of my assumptions about options were wrong, and there were actually plenty of benefits I had never before imagined.

Here’s a list of a few of the misconceptions about options and the reality behind them:

  • Options are high-risk.   In actuality, options offer exactly as much risk as you specify–on more flexible terms than stocks.

    EXAMPLE: Let’s say you think Acme Inc’s stock price–currently at $10–is about to go higher, and you only have $100 that you want to risk. 

    With stocks, you might buy 100 shares at $10 and set a stop limit at $9 to ensure no more than $100 could be lost.

    Unfortunately, that could happen on the very next day if the stock suddenly drops to $8 and then shoots up to $12–your stop limit is exercised before you have a chance to realize a gain.

    With options, you could buy $100 worth of calls on Acme Inc’s stock.  A call is a guarantee that you can buy a certain amount of a certain stock (usually 100 shares) at a certain price (“exercise price”) before a certain date (“expiration date”).

    Suppose $100 buys you one call of Acme’s stock at $9.  If the stock closes below $9 on the expiration date, you’ve lost your $100 entirely.

    But if the stock moves to the $12 imagined earlier, the value of the option purchased for $100 is probably somewhere between $350-$450, depending on various factors.  And yes, that’s money you can pocket immediately, rather than waiting for the expiration date to arrive.

    So options allow you to manage your risk much better than stocks.  You have the ability to calculate exactly how much risk you wish to take as well as how quickly that risk is realized.

  • Options are confusing.  I’ll admit that it takes a while to understand options.  It’s a bit like learning a foreign language in order to actually “think” in the new tongue.  But this comes with time and is very much worth the effort.  I plan to cover the basics of options trading over the course of the next few posts, but if you can’t wait, here are two complementary books that I recommend:

Options Made Easy: Your Guide to Profitable Trading (2nd Edition) 

The Bible of Options Strategies: The Definitive Guide for Practical Trading Strategies

  • Options don’t pay dividends.  True, but that doesn’t mean that options can’t be arranged as an income strategy.  Again, options provide much greater control than owning stock alone and can even be paired with stock to manage risk and losses.  Again, I plan to cover the corresponding strategies in future editions.

That’s enough for now, but hopefully, it has whetted your appetite to explore options.  Ultimately, I’ll be introducing some of my favorite options trading strategies as well as “real-world” play-by-plays of how I’m using options to grow my portfolio.

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