Just why are options so great in the first place? If you're still on the fence about trying your hand at options, this is a must-read article provided by Elizabeth Harrow of Schaeffer's Investment Research. If you enjoy this article and want to learn more about options you may even want to check out their options newsletter!
Options are cheaper than stocks.
In this economy, everybody's trying to save money. So, forgive me for pandering, but it's a fact that options are significantly less expensive than the securities on which they're based. Each option contract gives you control of 100 shares of equity, yet the cost to purchase an option contract is nowhere near the expense of buying an equivalent chunk of stock.
Premium: The price of an option contract that the buyer of the option pays to the option seller for the rights conveyed by the option contract.
When you purchase an option contract, you pay a premium to enter the trade. This premium is known as the ask price, if you're buying to open, and it's determined in the traditional manner by supply and demand.
By way of example, let's take a look at options on imaginary retailer You-Can't-Afford-It Stores Inc. (POSH). Let's say POSH closed yesterday at $46.39. It would cost you $4,639 to purchase 100 shares. By comparison, POSH's May 47.50 call closed yesterday at $1.83. (Hey, it's my imaginary case study: I get to pick the numbers.) In other words, it would cost you just $183 to purchase this call option granting you control of 100 shares of POSH.
As fair warning, I'm not a math expert, but I'm pretty sure you could save about $4,456 by purchasing the call option rather than investing in the shares outright.
Maximize your profits through the amazing power of leverage.
In addition to being cheaper than stocks, options also provide you with the magic of leverage. This nifty feature allows you to collect profits that are, in the best-case scenario, way out of proportion to your initial investment.
Leverage: The control of a larger number of shares with a smaller amount of capital. Leverage provides an option buyer greater profit potential using fewer dollars compared to holding a long or short stock position.
Sticking with our POSH example from above, let's say that Jill Trader purchased 100 shares at $46.39 for a total cash outlay of $4,639. Meanwhile, Susie Speculator bought to open 1 May $47.50 call for a total outlay of $183 ($1.83 x 100 shares per contract).
OK, bear with me, because we're going to have to use our imaginations for this next bit. Let's pretend that POSH rallies up to $55 per share by May expiration. Jill Trader unloads her 100 shares for $5,500, content in the knowledge that she's netted a profit of $861 (which translates to 18.6% of her initial investment).
Meanwhile, Susie Speculator sells to close her option contract, which is now worth $750. Susie's profit is $567, or 322.7% of her initial investment. Not only did Susie invest less capital than Jill, she more than tripled her trading dollars. Not too shabby, right?
And, if you can believe it, there are even more reasons why options are inherently superior to stocks…
Downside risk is limited in many option strategies.
At the risk of beating a dead horse, let's reverse our earlier scenario. Pretend that POSH shares plunge during the next 6 weeks, and by the time May-dated options expire, they're wallowing at $33 per share.
When you buy to open an option that expires worthless, your loss on the trade is limited to your initial cash outlay.
Our hypothetical investors have a very different reaction to the stock's slide. Jill Trader is panicking, because she's already lost $1,339 on paper, and the decline doesn't show any signs of slowing. She's faced with the choice of swallowing a big loss, or waiting it out and hoping the shares turns around.
Elsewhere, Susie's disappointed, but not devastated. She simply allows her out-of-the-money call to expire worthless, which means that her total loss on the trade amounts to no more than her initial investment of $183. It's not her best trading result ever, but it's definitely a more palatable outcome than Jill's.
Feel free to stop caring about price/earnings ratios.
At this point, I'm going to stop throwing math problems at you. Frankly, I find it exhausting, and I'm quite sure my endlessly patient colleague, Jocelynn Drake, is tired of checking my numbers. However, we will be discussing a few specific figures, namely: price/earnings ratio, price/book ratio, price/sales ratio… the list goes on.
Now, if you're used to investing in stocks, you're no doubt accustomed to researching the aforementioned ratios. These metrics offer clues as to whether a stock is overvalued or undervalued at current levels, and many traders will analyze these fundamentals before entering a position.
For all the reasons mentioned above(plus a few more), you have my full permission to throw these fundamentals out the window(well, mostly) when trading options. The fact is, these metrics simply don't matter as much to an option trader as they do to a buy-and-hold stock investor.
Let me explain. Thanks to your lowered initial investment, as well as the magic of leverage, you have a simple goal when you buy a call option. You want the share price to rise above the strike price prior to expiration, allowing you to collect your profit and exit the trade.
So, since you're not investing in the company for the long run, the traditional trading metrics shouldn't have much bearing on your analysis. So what if POSH's price/earnings ratio of 19 is higher than the average for its peer group? Even if the shares are expensive now, you can still reap a profit as long as they're more expensive by the time your option expires.
Instead, since we want the stock's price to make a fast, aggressive move in the right direction, we favor the Expectational Analysis method. By combining technical analysis with sentiment analysis, you can pinpoint equities that are poised to rally...or plunge, if you're playing puts.
Of course, fundamentals do play a part. If you're buying options ahead of earnings, you should be aware that premiums might be inflated by rising implied volatility. Or, if the pharmaceutical firm that you're buying calls on is due to release trial data within the next week, you should definitely have that event on your radar, too.
But, beyond the basics, you can really stop sweating the fundamentals. If you love crunching the numbers, though, don't worry. With put/call volume ratios, put/call open interest ratios, and more, there are still plenty of metrics for an option trader to play with.
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Best of luck to you with your options trading,
Schaeffer's Investment Research Team