Why Choose Options Instead of Stocks?

Stocks have been taking something of a pause this week, and the latest sentiment surveys and short interest data suggest traders are starting to grow cautious after the post-election rally. Against this backdrop, and considering the growing risk of a volatility pop, Schaeffer's Senior V.P. of Research Todd Salamone has in recent weeks been emphasizing the value of using options rather than holding stock, in order to minimize risk without completely missing out on further gains. Today we're going to take a step back and review the benefits of options in broader terms.

What Are Options?

First, a quick refresher. Stock options are contracts that represent the right to buy (or sell) shares of the underlying equity at a predetermined price, and by a predetermined date. Options are typically based on 100 shares of the underlying equity, and thus are classified as "derivatives," as they derive their value from an underlying asset. Call options gain value from a move higher in the underlying stock, while put options increase in value when the underlying stock declines. 

How Options Provide Leverage

For the sake of brevity, we'll hone in here on the advantages of buying calls. When you buy shares of a stock, your potential gains are, in theory, unlimited, while your potential losses are limited to the full original investment (plus any brokerage fees incurred). It's virtually the same with buying call options -- gains are potentially limitless, while your losses are capped at the initial premium paid -- except it costs much less to purchase calls than to buy stock outright.

Let's say you are bullish toward stock XYZ, which is currently valued at $50 per share. Buying a block of 100 shares requires an initial investment of $5,000 -- and thus a potential loss of up to $5,000. Instead, buying one at-the-money (ATM) call contract on XYZ may only cost $1.50 -- a total outlay of $150 ($1.50 * 100 shares per contract). That means you'll only spend $150 to place the bet, limiting your losses to this amount and leaving a substantial amount of cash free for allocation elsewhere, so you're not putting too many eggs in one basket, so to speak.

When you buy stock, your gains and losses are equal to the movement in the shares. If XYZ goes up to $55, shareholders gain $5 for every share owned -- a 10% profit on the original investment. But say you had purchased the ATM 50-strike call, for that initial outlay of $1.50 per shares, or $150 total. XYZ makes a move up to $55, and your call is now worth 5 points in intrinsic value. Assuming no time is left on the contract, you could sell the call at $5, and come away with a profit of $350 ($5 - initial $1.50 premium paid * 100 shares). That's a net profit of 233%.

Options Can Be Fine-Tuned

When dealing with stock, your choices are more or less limited to buying shares (a long position) or selling shares (a short position). With options, you can find a strategy that fits your expectations. Stock options can be bought and sold in a variety of different combinations, allowing traders to fine-tune strategies to match with their market outlook -- whether it's bullish, bearish, neutral, or somewhere in between. 

For instance, you can choose from a variety of expiration dates -- anywhere between a soon-to-expire weekly option and LEAPS that expire as far as three years in the future. You can also pick a strike based on not only your expectations for the stock, but your tolerance for risk. Moreover, you can profit from high volatility by employing a strategy such as a long straddle, which makes money from a major move in either direction, or profit from a sideways stock with a short straddle. You can even use options as hedges -- like the protective put -- or reduce risk without sitting out a rally with the stock replacement strategy.