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Resources » Articles/Knowledge Sharing » Education »
Advantages of Stock Options
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They have been around for more than 30 years, but options are just now starting to get the attention they deserve. Many investors have avoided options, believing them to be sophisticated and, therefore, too difficult to understand. Many more have had bad initial experiences with options because neither they nor their brokers were properly trained in how to use them. The improper use of options, like that of any powerful tool, can lead to major problems.
Finally, words like "risky" or "dangerous" have been incorrectly attached to options by the financial media and certain popular figures in the market. It is important for the individual investor to get both sides of the story before making a decision about the value of options.
These are the main advantages (in no particular order) that options may give an investor: they may provide increased cost efficiency; they may be less risky than equities; they have the potential to deliver higher percentage returns; and they offer a number of strategic alternatives. With advantages like these, you can see how those who have been using options for a while would be at a loss to explain options' lack of popularity in the past. Let's look into these advantages one by one.
Cost Efficiency
Options have great leveraging power. An investor can obtain an option position that will mimic a stock position almost identically, but at a huge cost savings. For example, in order to purchase 200 shares of an Rs.80 stock, an investor must pay out Rs.16,000. However, if the investor were to purchase two Rs.20 calls (with each contract representing 100 shares), the total outlay would be only Rs.4,000 (2 contracts X 100 shares/contract X Rs.20 market price). The investor would then have an additional Rs.12,000 to use at his or her discretion. Obviously, it is not quite as simple as that. The investor has to pick the right call to purchase (a topic for another discussion) in order to mimic the stock position properly. However, this strategy, known as stock replacement, is not only viable but also practical and cost efficient.
Less Risky - Depending on How You Use Them
There are situations in which buying options is riskier than owning equities, but there are also times when options can be used to reduce risk. It really depends on how you use them. Options can be less risky for investors because they require less financial commitment than equities, and they can also be less risky due to their relative imperviousness to the potentially catastrophic effects of gap openings.
Options are the most dependable form of hedge, and this also makes them safer than stocks. When an investor purchases stock, a stop-loss order is frequently placed to protect the position. The stop order is designed to "stop" losses below a predetermined price identified by the investor. The problem with these orders lies in the nature of the order itself. A stop order is executed when the stock trades at or below the limit as indicated in the order.
Had you purchased a put option for protection, you would not have had to suffer the catastrophic loss. Unlike stop-loss orders, options do not shut down when the market closes. They give you insurance 24 hours a day, seven days a week. This is something that stop orders can't do. This is why options are considered a dependable form of hedging.
Furthermore, as an alternative to purchasing the stock, you could have employed the strategy mentioned above (stock replacement), where you purchase an in-the-money call instead of purchasing the stock. There are options that will mimic up to 85% of a stock's performance, but cost one-quarter the price of the stock. If you had purchased the Rs.45 strike call instead of the stock, your loss would be limited to what you spent on the option. If you paid Rs.6 for the option, you would have lost only that Rs.6, not the Rs.31 you lost if you owned the stock. The effectiveness of stop orders pales in comparison to the natural, full-time stop offered by options.
Higher Potential Returns
You don't need a calculator to figure out that if you spend much less money and make almost the same profit, then you have a higher percentage return. When they pay off, that's what options typically offer to investors.
More Strategic Alternatives
The final major advantage of options is that they offer more investment alternatives. Options are a very flexible tool. There are many ways to use options to recreate other positions. We call these positions synthetics.
Synthetic positions present investors with multiple ways to attain the same investment goals, and this can be very, very useful. While synthetic positions are considered an advanced option topic, there are many other examples of how options offer strategic alternatives. For example, many investors use brokers that charge a margin when an investor wants to short a stock. The cost of this margin requirement can be quite prohibitive. Other investors use brokers that simply do not allow for the shorting of stocks, period. The inability to play the downside when needed virtually handcuffs investors and forces them into a black and white world while the market trades in color. But no broker has any rule against investors purchasing puts to play the downside, and this is a definite benefit of options trading.
The use of options also allows the investor to trade the market's "third dimension", if you will: no direction. Options allow the investor to trade not only stock movements, but also the passage of time and movements in volatility. Most stocks don't have large moves most of the time. Only a few stocks actually move significantly, and then they do it rarely. Your ability to take advantage of stagnation could turn out to be the factor that decides whether your financial goals are reached or whether they remain simply a pipe dream. Only options offer the strategic alternatives necessary to profit in every type of market.
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