Options can be complicated. But for astute investors, the advantages of options are worth the effort.
When you come across an ice cream shop on a sweltering August afternoon, there is an advantage to having some cash in your pocket. When a gorgeous spring morning turns into blustery, rainy afternoon, there is an advantage to having your raincoat with you. And if you should anger Smaug, and the fire-breathing dragon comes to ravage your town, there is no questioning the advantage of being able to send a quick text to Bard the Bowman. (Yes, we just mixed The Hobbit and investing advice. Please send editorial comments to Arwen Undomiel, 446 Peredhil Ln., Rivendell, Middle Earth.)
All joking aside, there are clear advantages to these and many other situations. The advantages of options, however, are not always so obvious. In fact, many investors feel that options are too complicated to deal with. However, once you move beyond the initial uncertainty, you realize that an option is another security, just like a stock or bond. And an option has a price and trades on an exchange, just like a stock or bond.
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Discovering the advantages of options
Before we delve into the advantages of options, let’s run through a quick refresher. An option is a contract tied to an underlying asset (like a stock or stock market index). Hence, they’re categorized as derivatives, because options derive their value from something else.
Each option controls 100 shares of a stock, so if the ask price of an option is 2.15, that’s actually $215.
Options come in two flavors: puts and calls. A put gives the owner the right to sell the underlying asset (the contract), and a call gives the owner the right to buy the underlying asset (the contract).
If you think the price of a certain asset will increase substantially before the option expires, you’d purchase a call option. If you think a stock will dramatically drop in value, you’d purchase a put. You can also sell, or write, puts and calls.
The strike price (sometimes called the “exercise price”) is specified as part of the option contract. The strike price is the price at which an underlying asset can be purchased or sold. For calls, this is the price an asset must rise above to make money; for puts, it’s the price it must fall below.
Once you have a grasp on what options are, exactly, there are seven advantages of options for investors seeking income or yield on their assets:
- Option income can be much greater than dividend income.
- Option income is not particularly sensitive to interest rates.
- Option income may be derived weekly, monthly, or in any time interval desired from available option expirations.
- Option writing strategies are highly flexible and can easily be implemented or closed at will.
- Unlike buying stocks, you can define your risk ahead of time in a way that’s impossible to duplicate through pure stock trading.
- Options trading can be as safe as you want it to be. When done right, the whole point of options is to reduce risk.
- Perhaps most importantly, one advantage of options writing is that it does not add to the risk of your existing stock position. In fact, it reduces the risk by the amount you take in from the option sale.
A case study demonstrating the advantages of options
To give this all a little perspective, let’s look at a real-life situation where the advantages of options are less theoretical and more concrete.
In January of 2019, Starbucks (SBUX) announced better-than-expected earnings. As the market action strengthened, we added Starbucks calls to our portfolio for four reasons:
- The stock was an earnings season winner.
- The calls we purchased were very cheap.
- We were able to keep our portfolio balanced with a wide variety of sectors and exposure.
- Option order flow had been steadily bullish in SBUX.
Our recommendation was to buy the Starbucks (SBUX) June 70 Calls (exp. 6/21/2019) for $3.60 or less. The most we could lose on this trade is the premium paid, or $360 per call purchased. Here’s how the trade worked out by June of that year.
We bought SBUX calls on January 31, when the stock was trading at 67.
By June, SBUX was trading at 84.5 and we sold our calls for $14.40, or a profit of over 340%. If you bought five calls you would have a profit of more than $5,500, and if you bought 10 calls you would have a profit of better than $11,000.
Not too bad if you ask us.
What is your experience with trading options? Share your story in the comments below.
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