This article today comes from my good friend Tom. Tom’s expertise lies in trading stock options and while long term investors might consider options as a risky instrument, the utility of options for hedging and strategic use of leverage cannot be overlooked and they should always be part of a serious investor’s arsenal. Hope you enjoy this gentle introduction and we wish you a Very Happy and Profitable 2013!
Options, fundamental analysis and the fence sitter may sound like a strange title for this article. However, you should know this article is aimed at the investor who is thinking about options, who I call the fence sitter, or who has started trading options albeit timidly.
Because this author was a stock broker (what are stock brokers?) and is an option trader with experience, I believe almost all investors should make options a part of their portfolio. They provide leverage, protection and reduce risk but that is getting ahead of the story.
Let me start by paying homage to fundamental analysis. It is considered the cornerstone of investing and all serious investors should have a handle on fundamental analysis.
Having said that though a person would be a fool to not acknowledge the other analysis – technical analysis. As an option player, it may be the most important side in analysis. Technical analysis with its charts and graphs and candlesticks and bars gives an immediate picture to the volatility of a stock.
It is hard to get an accurate picture of volatility from financial statements, SEC filings and accounting records. An options trader makes his living from volatility in my opinion. After all, if there was no movement in either direction, there would be no trading.
I mentioned the fence sitter above. If reported statistics are correct, options trading is the favorite financial instrument of small retail investors over the past few decades all over the world. The profit opportunity is the biggest reason for this surge.
Options trading allow investors with a very small capital base to gain disproportionately big profits and to control stocks that would otherwise be too expensive to own. The truth is a trader with a trading capital base of $100 has the potential to multiply that capital base 5 to 10 fold.
Like all investments, there is risk. The largest risk, as with stocks for example, is the loss of 100% of invested capital. Using the $100 just mentioned let’s look at a trade.
Suppose you have your eye on a $10 stock. You want to buy 100 shares but that would cost $1000 not counting commission and fees. You only have $100. However, you believe this companies stock will rise in value. You’ve researched the fundamentals and tweaked the technical and you are convinced there is nowhere to go but up.
The question becomes, how do you control 100 shares of this company? The only answer is options. Specifically a call option since you believe it will rise in price. Since this is an example I will assume you can buy a call for $1.
An option contract allows you to control 100 shares per contract. If you purchase this call option, you would spend $100 not counting commission and fees. If the price rises by $5 before your call option expires, your option will rise by $5. That means your $1 has grown to $6.
All numbers in this example are rounded and presumptions of an event that could happen. At $6, you decide to sell. Your $100 capital is returned along with a profit of $500 for a total return of $600.
That is leverage, control and almost no risk all in one trade. Will you always enjoy this kind of success? The answer is of course not. However, once you become a student of options, you understand how you must play the trade.
Let’s use the same example of a $10 stock offering an option of $1 but the stock decreases in price instead of rising. Let’s say it drops to $5. Theoretically your $1 option will drop to 50 cents. At that point, you lose faith in your estimation.
You decide to sell. Your account will be credited with $50 thus preserving one half of your capital. You have also erased the possibility of a 100% loss.
Please note, percentage wise, owning the stock or owning the option, it is 50%. However, capital wise, the difference is $50 versus $500.
The beauty of options is the flexibility they offer the investor. You do not fear volatility as options allow you to play the upside, the downside or both. An option trader does that through the type of option he uses.
A call option lets you play the upside while a put option lets you play the downside. That $10 stock used in the example could have had fundamentals that showed it was headed south. Had that been the case, the $100 investor would have purchased a put option. If the stock had indeed declined in price and the investor exercised the option, he would have made a profit.
I will repeat myself. That is the beauty of options. By the way, an option gives you the right to buy, or sell, the underlying security but it does not obligate you to buy or sell. You can let the option expire and not be obligated to buy or sell the underlying security. Again, you enjoy more flexibility leaving you a wider opportunity for profit.
None of the examples or explanations implies you will not have losing options trades. The market goes up, the market goes down and the market goes against trades that look like a sure thing. All investors have to live with those facts.
However, for the investor looking for leverage, less risk exposure and control, options may be your cup of tea. By the way, options also offer you a way to increase your profits. This is done through selling, or writing as it is called, either a call or put option.
That strategy is too advanced for the fence sitter or the beginner. But, it exists and can increase your return by double digit percentages if done correctly. I will leave the explanations for a later date.
For now, keep an open mind about options. Maybe start with a toe in the water. If your experience is pleasant, you may wish to pursue a deeper involvement in the option trading arena.