Options Investing

Buying Options as a 'long term' investment alternative.

After learning about stock options it seems to be a very good alternative to purchasing stocks, especially when dealing with smaller sums of money.  The unlimited profit potential and limited risk can make options a great low risk investment.

First the definitions simplified:

  • Call Option - contract to buy 100 shares of a stock at a guaranteed price on a certain date.
  • Strike price - the 'guaranteed price' from the definition above.
  • Expiration date - the date in which the option is exercised (you buy the shares for the predetermined price).
  • Option premium - the price of the option (the quotes are listed on a per share basis, since one contract = 100 shares you multiply the quote by 100 to get the contract price, see the Basic How-to section)
  • Break-even price - this is the strike price plus the option premium, this number only applies at the option expiration, you can have a gain even if the stock is below this value, more on this later.

These options contracts are traded just like stocks with prices fluctuating all day long.  You can sell your option at any time, so the strike price and break-even price really only apply if you hold it until the expiration date.  For my purposes, I will assume all options are sold before the expiration date.  I will only be discussing the Call option here, buying a Put is similar to shorting a stock, betting that it will fall, which doesn't fit into my discussion of using options as an alternative to buying and holding stocks.

Lets look at an example of buying a stock vs. an option using some real numbers of some company:

Yum! Brands, YUM, is at $39.97.  Its May 2010 now, lets say you thought this was a good price to buy and you thought it would go up in the next year or so.  I don't really have any pointers regarding stock picks, I am just illustrating how options can decrease your risk and increase profits.  Lets say you were going to buy 200 shares, so that would set you back $7,994.  Maybe this is a small sum of money to you, its not to me, but I want to illustrate how options can level the field a bit.  There are ways you could protect this $7,994 by using stop loss orders, etc.  But lets look at using a call option as an alternative and assume you buy/hold the stock in that scenario.  The YUM $50 strike January 2012 call option is going for $2.56, this means for each contract you can buy 100 shares of YUM for $50.00/share on January 2012.  Lets compare the stock purchase with 2 Call purchases(equivalent shares):
200 shares of YUM:
                      STOCK              OPTION           
cost                $ 7,994             $    512
YUM hits $50    $10,000             $       0            (actually depends on when it hits $50)
YUM hits $60    $12,000             $ 2,000             
YUM hits $70    $14,000             $ 4,000
YUM hits $80    $16,000             $ 6,000                        
YUM hits $90    $18,000             $ 8,000           (options profits limited only by the time)
or YUM is a loser:
YUM hits $30    $ 6,000             $      0             (losses limited, you can't lose more than the price paid for the option)
YUM hits $20    $ 4,000             $      0
YUM hits $10    $ 2,000             $      0

These are worst-case scenario numbers for the option column.  The break-even price for the example here is $52.56 since the stock would have to reach that price on expiration day to give you the 2.56 gain which would cover your initial cost of the option.  There is a 'time value' to each option price.  This time value decreases the closer you get to expiration date, so you could have YUM go to 50 a month or two after you buy the call and have a nice profit because of the time value factor.  You may decide that you want to take the profit and sell (maybe get back in when it cools off).  Deciding when to take the profit is another problem.  I tend to sell after a 200% or 300% profit, you can always buy right back in at a higher strike(similar to your original purchase).  This will lock in the gains limit future losses and keep you in the stock if you think it may continue higher.  In this example you are buying a year and a half of time for the underlying stock to appreciate!

This method can be scaled up or down to suit your cash level, you can buy contracts for under $100 on good companies.  In the example above, if you didn't want to risk $500, you could buy 1 contract for $256, or you could buy a higher strike price and get it down even lower.  Of course the higher the strike lowers the odds, thats why its cheaper.

I am not endorsing YUM and do not own any YUM stock or options.

If you want to learn more in depth, optionseducation.org has lots of good information for beginners, but don't get too bogged down in the advanced strategies, there is something to be said for KISS (Keep It Simple Stupid).  When browsing that site, keep in mind the only strategy discussed here is buying 'call' option LEAPS.