Why Options? (Part 4)

After getting past an option myth and finally mentioning some option truths, today I will begin talking about some advantages to trading options.

What follows is content that few people in the financial industry will tell you about.

First, options allow for cost efficiency:  the ability to almost mimic a stock position at a big cost savings.  Consider stock replacement as an example.  Purchasing 400 shares of a $40 stock costs $16,000.  Purchasing four $10 calls may be done for $4,000.  Since one option contract represents 100 stock shares, this is a very similar position.  The leftover $12,000 can stay safely in cash or be used for another position.

A second advantage is that options offer a limited-risk alternative. A long option position can never lose more than its original cost. In the previous example if the stock goes to zero then the stock position would lose $16,000 whereas the option position would only lose $4,000.

Advantage #3: options can succeed where stop-losses can fail. Suppose XYZ is purchased for $50 with a stop-loss order entered at $45 to prevent loss of greater than 10%. After the close, XYZ announces allegations of high crimes among the upper management. Next morning, stock opens at $20 and the stop-loss order triggers immediately for a 60% loss.

Now consider the purchase of a $45 put instead of placing that stop-loss order. The put does cost a few dollars whereas the stop-loss order is free. As with any insurance, though, you get what you pay for. The most you can lose on the put is the price paid but it will hold (gain) its value point-for-point for each dollar below $45 the stock falls. In addition, a volatility spike in the midst of a huge selloff would cause the put to increase even more.

I will continue discussion of option advantages in the next post.