4 Ways Options Are Better Than Stocks

04/11/2011 11:03 am EST

Focus: OPTIONS

Elizabeth Harrow

Financial Analyst, Schaeffer's Investment Research, Inc.

Buying options instead of underlying equities like stocks has several distinct advantages including limited risk and leveraged profit potential. Here, an options expert names four good reasons to favor options over stocks.

Options are officially more popular than ever. On Friday, the Options Industry Council (OIC) announced that 417,188,575 options contracts changed hands in March—up 18.9% on a year-over-year basis, and representing a new monthly options volume record.

Clearly, plenty of traders have already caught on to the benefits of trading these derivatives. But if you're still on the fence about trying your hand at options, read on and allow me to convince you.

1) Options Are Cheaper Than Stocks

In this economy, everybody's trying to save money. So, forgive me for pandering, but it's a fact that options are significantly less expensive than the securities on which they're based. Each option contract gives you control of 100 shares of the equity, yet the cost to purchase an option contract is nowhere near the expense of buying an equivalent chunk of stock.

When you purchase an option contract, you pay a premium to enter the trade. This premium is based on several factors, including the price of the underlying equity.

By way of example, let's consider tech giant Oracle (ORCL). It would currently cost you around $3,429 to buy 100 shares of the stock. However, you'd shell out just $0.69, or $69, to purchase one contract of the at-the-money April 34 call, which gives you control of 100 shares of ORCL.

As fair warning, I'm not a math expert, but I'm pretty sure you could save about $3,360 by purchasing the call option rather than investing in the shares outright.

2) Options Use Leverage to Maximize Your Profits

Because they're cheaper to purchase than an equivalent number of shares, options also provide you with the magic of leverage. This nifty feature allows you to collect profits that are, in the best-case scenario, way out of proportion to your initial investment.

Sticking with our ORCL example from above, let's assume ORCL rises to $40 by front-month expiration. Your shares would be worth $4,000—a gain of $571 from your initial investment, or 16.7%.

Meanwhile, your purchased April 34 call would carry six points of intrinsic value (stock price of $40 minus strike price of $34), so your contract could be sold to close for $6, or $600. This represents about 870% of your initial investment of $69. Quite an improvement from 16.7%, right?

And, if you can believe it, there are even more reasons why options are inherently superior to stocks.

3) Downside Risk Is Limited in Many Option Strategies

At the risk of beating a dead horse, let's reverse our earlier scenario. Pretend that ORCL shares plunge during the next few weeks, and by the time April-dated options expire, they're wallowing at $25 per share.

If you had purchased the shares outright, your stake would be worth just $2,500. In other words, you would have lost $929, or 27% of your original investment—and you're still exposed to any additional downside.

On the other hand, that $69 you paid to buy one ORCL call is the most you can possibly lose on your option trade, even if the stock falls as far as zero. While your maximum profit potential is theoretically unlimited when you buy a call, your maximum loss is limited to the initial net debit paid to open the position.

4) Throw Fundamentals Out the Window

If you're used to investing in stocks, you're no doubt accustomed to researching various different permutations of the price/earnings ratio. These metrics offer clues as to whether a stock is overvalued or undervalued at current levels, and many traders will analyze these fundamentals before entering a position.

For all the reasons mentioned above—plus a few more—you have my full permission to throw these fundamentals out the window when trading options. The fact is, these metrics simply don't matter as much to an option trader as they do to a buy-and-hold stock investor.

Let me explain. Thanks to your lowered initial investment, as well as the magic of leverage, you have a simple goal when you buy a call option. You want the share price to rise above breakeven (the strike price plus the initial premium paid) prior to expiration, allowing you to collect your profit and exit the trade.

So, since you're not investing in the company for the long run, the traditional trading metrics won't have much bearing on your analysis. So what if ORCL's forward price/earnings ratio of 15.78 is a little steeper than some of its peers? Even if the shares are expensive now, you can still reap a profit as long as they're more expensive by the time your option expires.

Of course, fundamentals do play a part. If you're buying options ahead of earnings, you should be aware that premiums might be inflated by rising implied volatility. Or, if the pharmaceutical firm that you're buying calls on is due to release trial data within the next week, you should definitely have that event on your radar, too. But, beyond the basics, you can stop sweating some of these traditional fundamental metrics.

By Elizabeth Harrow, contributor, Schaeffer’s Trading Floor Blog

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