Some retail investors have a simple investment strategy: Buy stock in a good company with attractive earnings, growth, or dividend yield potential. These investors might hold stocks in an account and hope they produce positive returns. Some investors might avoid stocks with high prices that can eat up large percentages of a portfolio. They limit their exposure in one stock in order to spread the risk out—the old eggs-in-several-baskets approach. In short, options on stocks don’t enter their universe as an alternative to simply buying a security.
Let’s see if we can, through education and discussion, change that thinking.
What if I told you that even a small account could invest in shares of Apple ($110), Chipotle ($444), or Facebook ($110) with the same amount of upside potential and potentially lower risk or capital outlay versus simply buying the stock? Some options strategies are designed to make that happen.
Currently, 100 shares of Apple (AAPL) cost about $11,000, but a bullish strategy on AAPL can potentially be executed for a fraction of that cost and with significantly less downside risk. Instead of simply buying AAPL stock, a qualified investor could purchase a long-dated call option (January 2017 expiration) with a strike price of 100 for $15.70 per share, or $1,570 ($15.70 x 100 = $1,570 plus transaction costs). She’ll enjoy the same upside potential for approximately 14% of the cost. It’s also appealing that the total risk on this trade is the amount invested: $1,570 (plus transaction costs).
This call option strategy means that smaller accounts can afford to participate in higher-priced stocks, while larger accounts can take larger positions for the same amount of capital. However, there are still some advantages to trading long stock instead of call options.
Call options’ breakeven point is higher than the current stock price because of the extrinsic value (also known as time value, and measured by the option greek theta) associated with a call option, especially when it comes to an expiration date some 280 days in the future. The January 2017 100 call has extrinsic value of just over $5 per contract, which introduces daily decay, or theta, into this trade. Conversely, a stock doesn’t carry the risk of theta. A stock purchase becomes profitable as soon as the underlying price rises above the purchase price (after accounting for commissions). Also, the owner of a call option (versus long stock) does not receive any dividends in the underlying.
The owner of a call option does have to be aware of expiration and the potential conversion of an in-the-money option into stock. Some action is required before expiration. The investor can exercise the option and take delivery of the underlying stock, although the holder of a long option can exercise at any point prior to expiration. It's important to note that most standard stock options in-the-money by $0.01 or more at expiration usually will be automatically exercised. The investor also can close the trade by selling the option at any time before expiration. Another alternative is to extend the trade by rolling the existing option to an even longer-dated call. However, if the option is out of the money by expiration, it will expire worthless. This is all in contrast to the “buy and hold” practice of purchasing long stock, which requires much less attention than a long call option.
There are several other directional, risk-defined option strategies that we discuss each day on Swim Lessons from 10:30 a.m. to 12:00 p.m. CT. Please join us as we take thinkorswim® clients from beginner to advanced options and futures trading strategies. We also offer market updates and current-event discussions on the thinkorswim platform.
Daily Swim Lessons: Dive In
Join rotational Swim Lessons on the thinkorswim® platform. Ease into the wadingPool or jump right into thinkorswimPlunge.