What are stock options, and can they increase your profits?

What are stock options, and how are they used for investing? An option is a contract between a buyer and a seller, based on an underlying security, usually a stock.

The buyer pays the seller a fee, or premium, in exchange for certain rights to the stock. In exchange for the premium, the seller assumes certain obligations.

Options trade through stock exchanges, with prices quoted each day in the financial section of newspapers. Each options contract is for 100 shares of stock. So one contract quoted at $5 will cost you $500 (before commissions).

Each contract has a limited life span, or time to expiry—usually less than nine months. The expiry date is the date on which the contract expires. The strike, or exercise price, is the price at which the rights granted to the buyer can be exercised. There are two types of options:

1. Call options give the holder or buyer the right to buy the underlying security at a specified strike price until the expiration date. The seller of the call has the obligation to sell or deliver the underlying security at the strike price until the expiry date.
2. Put options grant the holder or buyer the right to sell the underlying security at the strike price until the expiry date. In turn, the seller or writer of the put has the obligation to buy or take delivery of the underlying security until expiration.

Here is how brokers pitch options to investors.

Portfolio insurance. The sales pitch: Suppose you hold a high-quality stock in your portfolio that you believe will rise in price over the long term. But you’re concerned about a possible downturn in the market in the short term. You can buy a put option for the stock giving you the right to sell your stock at a set price (the strike price) within a certain time frame (before the expiry date). If the stock price stays above the strike price, you would let the option expire unexercised — you only lose the cost of the put. But if the market declined drastically, you could exercise your option and sell your shares to the writer of the put at the strike price. You could then, if you wanted to, buy the shares back again at the lower market price.

The reality: Buying puts for insurance is like betting against yourself. You’re better off just selling the stock if you think it’s going to drop in price. Furthermore, you may be right about a market decline, but you have to hope it happens before your put expires. If the decline takes a while to occur, you could continue to buy puts for a considerable period of time. That would eat steadily into your eventual profits.

Increase income from your stock holdings. The sales pitch: You hold shares of a company that you think will remain at around today’s price for a while. You’re reluctant to sell the stock, however. If you sell call options on your stocks, you’ll pocket low-risk premium income even if your stock just sits there. Selling call options on a stock you own is known as a covered call. This strategy will not only generate extra income, but will lower risk and volatility.

The reality: If you feel your stock is not going to rise in price, then sell it. What’s more, by  consistently selling covered calls on your stocks, you’ll eliminate all chance of being in on a big gainer. The holder of your call will exercise away your potential big winners. You need a few big gainers in your investing career to offset the inevitable losers. As well, some conservative stocks, such as the banks and utilities, have lately shown an ability to go on long and sustained upward trends. You’d have missed out on all those movements with a covered call strategy. So investors who consistently sell covered calls on their portfolios will substantially underperform over time. Your broker will continue to profit, however.

Lock in a future price for a stock.The sales pitch: Let’s say you think the price of a stock is going to rise but you don’t have the money to buy it right now. However, you can buy a call now, and lock in the future price of the stock. The total price that you’ll eventually pay for the stock will be the strike price plus the cost of the call option.

The reality: If you guess right, and the stock rises, you’re cutting into your gains with the cost of
the option plus commissions. If you guess wrong, and the stock price falls, you still lose the total
price of an option and commissions — even if you never owned the stock.

Make money whichever way the market moves.The sales pitch: Buying options in a “combination” position, lets you make money no matter which way the market moves. You don’t care whether a particular stock goes up or down—as long as it makes a significant move. And as your broker will tell you, in today’s volatile markets, this is a pretty safe bet.

Combination positions are positions in more than one option at the same time. Spreads and straddles are two of the most common types of combinations. A spread involves being both the buyer and writer of the same type of option (puts or calls) on the same underlying interest, with the options having different exercise prices and/or expiration dates. A straddle consists of purchasing or writing both a put and a call on the same underlying interest, with the options having the same exercise price and expiration date.

Since one of the options in a combination will almost always finish in-the-money—have some value at expiry— the straddle is considered a ‘conservative’ options trading strategy.

The reality: Combination transactions, such as option spreads, are much more complex than buying or writing a single option. You’ll likely need the services of a broker specializing in that area. These brokers will use tools, such as computer models of past stock trends, to put you into combinations. But past price movements are no guarantee of future trends.

One problem with combinations is that options are often illiquid. They don’t trade a lot of volume
on any given day. So it may be impossible to simultaneously execute transactions in all of the options involved in the combination, when you want to close out a trade. Or if you can execute the trades, it may not be at the prices you need to make money. Even more risky is if you’re only able to close out one side of a transaction and not the other. That leaves one side of the trade open, and that entails a higher level of risk than expected in a combination.

Also, the transaction costs of combinations can be especially significant, since separate costs are incurred on each component of the combination. You pay commissions on both sides of the combination. This means you probably require a substantial favourable price movement in the underlying stock before a profit can be realized. If the stock stays around the same price while your combination is in effect, you lose two commissions, plus the costs of both the calls and puts.

Leverage: The sales pitch: Buying a call lets you benefit from an increase in the price of a stock, while only putting down a fraction of the cost of buying the underlying stock. And unlike buying stocks on margin, you know exactly how much you can lose—the premium for the option. If the price of the stock rises substantially, you make a huge return on your money. On the other hand, your potential loss is limited to the cost of the option and your commissions. You only need one big winner to make up for a few losers.

The reality: This strategy limits your loss to the cost of the option. But you will usually lose 100%
of your investment—and often in a very short period of time.

Options have lots of other drawbacks….

High costs. You pay commissions when you buy and sell options. Commissions take a large part of any profits you make, particularly if you trade in small quantities. In addition, every trade costs you money in ‘slippage’ — the difference between the bid and the ask. That difference is quite large with options. An example is the Microsoft call, which had a bid price of $4.30 and an ask price of $4.70. You would lose $40 ($0.40 times 100), or 40%, instantly if you bought and then immediately sold a contract, even excluding commissions.

Limited room for error. Unlike common stocks, an option has a limited life. Common stock can be held indefinitely in the hope that its value may increase. A stockholder can wait out a temporary downturn in a stock in the hope of eventually realizing a profit.

On the other hand, every option has an expiration date. If an option is not sold or exercised prior to its expiration date, it ceases to exist as a financial instrument. For this reason, an option is considered a “wasting asset.”

Part of the price that you pay when you buy an option is for “time.” And as each day passes, you lose more and more of the “time” premium. The problem is that you have to be right in three different ways with options in order to profit. Otherwise, you lose. You must accurately predict three factor—direction, magnitude and time frame.

1. Direction: In order to make money with an option, you have to be correct about the direction of the price of a stock. If you buy a call option, you’re betting the price rises. With a put option, you’re predicting the stock price will fall.
2. Magnitude: Assuming you are correct about the direction of the stock price, you also must be able to predict the minimum amount that a stock will move. If the stock moves up or down by only a small amount before expiry, you’ll still lose money. That’s because your profit won’t offset your commissions or the difference between the bid and ask prices.
3. Time: The fact that options become valueless upon expiration means that an option holder must not only be right about the direction of both an anticipated price change in the underlying interest, and the magnitude of the move, but the holder must also be right about when the price change will occur. If the price of the underlying interest does not change in the anticipated direction before the option expires with sufficient magnitude to cover the cost of the option, the holder will lose all, or a significant part of, the investment in the option.

Options or stocks. Which is best ?

Now that you’ve learned what stock options are, you can make a better judgement of whether they fit your investment style. You can get lucky in options, just like anything else. But almost all non-professional options traders wind up losing money. Professional traders follow the options market minute by minute. When a true bargain appears, they jump on it.

Many pros work for brokers, so they pay negligible commissions. They are your competition. Professional options traders (the successful ones, at any rate) are more like business people than investors. Rather than trade options, they make a market in them. If an option is trading around $2.50, they may be willing to sell at $2.60 or buy at $2.40.

To make money in options, you have to you have to outguess other options-market participants by a large enough factor to pay commissions, which can be substantial. Some brokers claim to specialize in helping retail investors outguess the market, based on studies of what would have paid off in, say, the past five years. But all other market participants are also privy to that historical information. So things are unlikely to work quite the same way in the next five years.

In the long run, options trading is what mathematicians refer to as a ‘negative-sum game’: one player’s gain is less than another’s loss, because their gain is minus commissions and other costs. In the end, the brokers end up with most of the money.

If you must trade options, do so as little as possible. And if you do trade options, trade them outside your RRSP. That’s because if you lose money on options in an RRSP you suffer a double loss. You also lose the tax-deduction value of a loss in your RRSP.

Outside your RRSP, you can use capital losses to offset taxable capital gains in the current year, the three previous years, or any future year. The tax savings will help offset your inevitable losses.

There’s a large element of risk in aggressive investments, but you can make money in them. In options, most investors will eventually lose. That’s the key difference between aggressive investing and options. If you want to invest aggressively, our best advice is avoid options.

Have you traded stock options before? Were you profitable? Share your experience in the comments.