Should You Buy the Stock or the Option?
11/22/2010 11:23 am EST
Traders face many hard decisions every day—buy or sell, add or lighten, stand aside or get involved—and among them is the choice between trading options or common stock.
There are no doubt benefits and shortcomings of both choices, as everything literally is a tradeoff.
Common stock is usually much more liquid, it can be traded in the after hours or pre-market, and it’s by definition 100% exposure to the company. However, it is more capital intensive since it’s not a leveraged position, which means less room for other positions in an account. Common stock alone is also going to carry with it greater dollar risk, as a major headline can bring tremendous gap potential.
Options are leveraged, they offer lots of versatility and possibilities (speculation, hedging, income, etc.), and they are less capital intensive. However, liquidity is often inferior compared to common stock, options can’t be traded as many hours of the day as stocks can, and they offer only fractional exposure to the underlying stock.
The Case for Options
Options can be an excellent vehicle for trading, provided the situation is well suited to them. The three biggest considerations for options are:
- Time expectation for the trade
- Liquidity of the options being traded, and
- Risk involved in the trade
Let’s break those down.
First things first, the time you expect to be in the play is important because options will often times carry a bid/ask spread of up to ten to 15 cents. For a stock that’s not a huge deal, but for an option, which might only be trading at $2 or less, that’s a big percentage if you pay the spread both ways (market order getting in and out). So if you’re looking at being in a trade for at least a couple of days, that’s usually much better for an options trade than if you’re just looking to scalp it over the next half hour.
Second, there are quite a few stocks that have high trading volume, but for whatever reason, their options are just not heavily traded. For any trade I take, whether a stock or an option, I want to feel confident there will be buyers when I go to sell, and sellers when I go to buy. Sufficient liquidity is a requirement for any trade, whether in options or common stock. So taking a look at the open interest, the volume, and the bid/ask spread is important for gauging the liquidity of the options. When in doubt, take a look at the highly liquid options like QQQQ, SPY, or mega-cap stocks like MSFT or INTC. That will help you get a feel for how tight the market is in the options you’re considering. You don’t ever want to be the big player in any contract.
Third, limited risk is an advantage that options carry, such as buying put options versus being short stock. Risk is defined with the puts, and is theoretically unlimited with the short stock. Options are a great choice in particular when the stock has the potential to gap big, whether due to news coming out or simply based upon recent price history of the stock. Always consider the risk involved when weighing options versus common stock, as that’s an important element of the decision-making process.
Finally, here are a few occasions to consider options rather than the common shares:
1. In front of big news (earnings, conference calls, or anything else scheduled)
2. When limited on capital (the leverage of options helps offset a limited amount of funds)
3. When the stock moves are too shaky to sit through (when a really wide stop is necessary)
4. When trade time frame is between a couple days and a few weeks