Most of my friends that are in the market trade stocks, not options. The popular misconception is that options are very risky. My belief is just the opposite, however, I believe stocks are more risky. Now that I trade options directionally, I think it is easier to show a direct comparison between the two trades, since stocks are always traded directionally.
On November 8, 2010, I want to buy DECK stock. The stock has been moving steadily up and my teenage daughter tells me all the kids want UGG boots (made by Deckers Outdoor Corp) for Christmas. Here is the daily chart for DECK:
I can purchase 200 shares of DECK at 62.67, for a cost of $12,534. The plan is to get out if there is a 10% drop in the stock, which would be at a price of 56, giving a loss of $1334. For the options trade, there are a couple of ways to do it. I could either use the same amount of capital as the stock trade ($12,534), or I could use the same amount of risk as the stock trade ($1334). These calculations would direct me to a different number of contracts to use since an options risk graph is not linear like a stock risk graph. I prefer to think in terms of controlling risk, so I will use the second option, and set up a trade with the same amount of risk at a 10% drop in stock price. For the options trade I will start with a diagonal spread, which is like a covered call but has a long call substituted for the stock. So on November 8 I buy the Mar 2011 55 call for 11.17 and sell the Dec 66.67 call for 1.92 to create my diagonal. To give me close to the same risk as the stock trade, I will do this with 4 contracts which makes my total cost $3700, about 30% of cost of the stock trade. Here is the first advantage of options over stocks: If DECK were to drop to 0 the next day, the stock trade loss would be over 3 times that of the option trade loss.
After a couple of days, DECK moves up, and I decide to adjust the options trade by buying back the short option I sold earlier. My plan is to only have a long call when the stock is running up, and "cover" the long call by selling a short call when the stock pulls back. The short call gives me some downside protection. On November 10 I buy back the short call for $1.35. There is not a similar corresponding trade I could make to the long stock position, so I continue to hold the 200 shares bought at 62.27.
For the next 6 days DECK trades lower, but never for 2 consecutive days, so I continue to hold the long call option purchased for 11.17.
On November 16 DECK starts moving up. It reaches 68 on November 22
and has risen enough that I can make an adjustment to my option position to capture some profit but still keep my position open. This is done by "rolling" my long call up a strike from 55 to 60 and also adding 2 additional options giving me a total of 6. I sell the 4 Mar 2011 55 Long calls for $15.10 and buy 6 Mar 2011 60 Long calls for $11.55. Normally I try to make this adjustment for a small credit but in this case the trade was a small debit, but I will try to do the next adjustment for a credit to balance this one out. So my options position now has 6 long calls instead of 4 that I started with for nearly the same risk I originally started with. This is the second advantage of options over a stock trade: When a trade is working I can make adjustments that increase the reward potential without increasing the risk. The only similar thing I could so with a stock position is to sell off some of the shares which decreases my risk, but also decreases my profit potential going forward.
DECK continues moving higher going up 9 straight days so on November 30
I am able to make another adjustment to the option position to capture more profits. I sell the 6 Mar 2011 60 Long calls for 19.28667 (these are actual trade prices, by the way, not paper trades), and I buy 8 Mar 2011 70 Long calls for 12.215.
DECK has continued to move up in December and closes today at 83.11.
DECK has been perfect for a long stock trade and the position is up 20.34 from the original purchase, a gain of 32% or $4088.
However, the stock gains are not even close to what the diagonal option position has gained.
Profit is currently at $10,030 on an original debit of $3700 or 271% profit for the option trade. Also with the credits I received on the adjustments the current debit is LOWER than the original debit and is $3330. This illustrates the third (main) advantage of options over stocks: The leverage of options allows for much larger gains than a stock position would give with lower risk.
Posts
