Pros and Cons of a High-risk Trading Strategy
Buying and selling stock options is among the riskiest type of investing, but can pay off in huge returns. A stock option is the right to buy (call option) or sell (put option) a specific number of shares at a certain price, by a specified date.
Options are classified as either in-the-money or out-of-the-money. In-the-money options can be exercised at their current price, and out-of-the-money options require the price to increase for a call option, or decrease for a put option, for the stock to be exercised.
For example, if a stock is priced at $37, a call option with an exercise price (also called a strike price) of $35 will be in-the-money, and a call option with a strike price of $40 will be out-of-the-money.
Positives of In-the-Money Options Trades
The main positive aspect to buying an in-the-money option is the potential for larger gains in a very short period of time. For example, if the price of XYZ Corp stock is currently $22, a call option with a strike price set to expire one month at $20 from today may be priced at $3.
This hypothetical in-the-money option carries a premium of $1. If this option is for 100 shares, the cost of the transaction would be $300 plus commission. For $300, the buyer has the opportunity to participate in the profits (and losses) of 100 shares of stock, which without options would require an investment of $2,200.
The best result would be for the price to rise a proportionately large amount, for example, to $25. This will generally result in the option price rising above $5 where it can be sold for a profit of at least $2 ($500 proceeds), or the option can be exercised at a favorable price.
If a market exists for the option, it can be sold prior to the expiration date, taking profits early, or salvaging some part of the investment, even if it is at a loss.
A put option works in the same fashion in the other direction. Profits are made from a decrease in price. This is similar to selling a stock short, but a put option limits the possible loss to the price of the option, while with shorting stocks, the possible loss is unlimited.
Negatives of Trading Options In-the-Money
The primary negative to options is that all of the investment is at risk for a particular time period. If, in the above example, the stock price declines below $20, the option will decline in price, until it becomes worthless at expiration.
Options are sold at a premium, generally determined by the Black-Scholes method, which accounts for the stock’s price, volatility, and time remaining until expiration. Even if a stock price does not decline, the value of the option will still erode as it approaches the expiration date.
Prices on options are still subject to market forces and premiums can increase in anticipation of earnings reports or other expected news. Since the option price is dependent on the underlying stock price, changes in the stock price have a magnified effect on the option price.
Commissions on options are higher than on stock purchases, with most brokerages charging a price for the transaction plus an additional price per option contract. Options are not marginable.
Option Buying Summary
Buying options can be combined with stock purchases for a worthwhile investment strategy for use in hedging, or reducing the risk of the offsetting stock.
Purchasing options without the stock purchase also (known as buying naked calls or puts), is a high- risk form of speculation which can produce very high returns or complete loss of the purchase price.