Exchange-traded options first started trading back in 1973. But over the past decade, the popularity of options has grown in leaps and bounds. According to data compiled by the Options Industry Council, the total volume of options contracts traded on U.S. exchanges in 1999 was about 507 million. By 2007, that number had grown to an all-time record of more than 3 billion.
So why the surge in popularity? Although they have a reputation for being risky investments that only expert traders can understand, options can be useful to the individual investor. Here we’ll look at the advantages offered by options and the value they can add to your portfolio.
The Advantages of Options
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. However, it is important for the individual investor to get both sides of the story before making a decision about the value of options.
There are four key 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. (If you need a refresher on options, see our Options Basics Tutorial.)
1. Cost Efficiency
Options have great leveraging power. As such, 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 $80 stock, an investor must pay out $16,000. However, if the investor were to purchase two $20 calls (with each contract representing 100 shares), the total outlay would be only $4,000 (2 contracts x 100 shares/contract x $20 market price). The investor would then have an additional $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. (For more on this strategy, see Using Options Instead Of Equity.)
Example
Say you wish to purchase Schlumberger (SLB) because you think it will be going up over the next several months. You want to buy 200 shares while SLB is trading at $131; this would cost you a total of $26,200. Instead of putting up that much money, you could have gone into the options market, picked the proper option that mimics the stock closely and bought the August call option, with a strike price of $100, for $34. In order to acquire a position equivalent in size to the 200 shares mentioned above, you would need to buy two contracts. This would bring your total investment to $6,800 (2 contracts x 100 shares/contract x $34 market price), as opposed to $26,200. The difference could be left in your account to gain interest or be applied to another opportunity that provides better diversification potential, among other things.
2. Less Risk – 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. (To learn more about gaps, see Do stop or limit orders protect you against gaps in a stock’s price?)
Options are the most dependable form of hedge, and this also makes them safer than stocks. When an investor purchases stocks, 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. Via investopedia
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