Why Options Are Becoming Essential for Today’s Traders

Why buy calls when you can just buy the stock? It's a long-running debate among active investors, especially those contemplating a move into the derivatives market. Still, it's evident that more investors are supplementing their portfolios with options trading.

So, what are the key differences between a traditional long stock play and a long call? Let's start with the advantages of owning shares. The main one is the dividend payout, in which option buyers do not partake.

Stock holders are also less likely to lose their total dollar investment compared to options traders. However, a stock position typically requires far more capital upfront, and that’s where options start to shine.

Options are attractive because of their low relative cost, as well as the leverage they provide compared to their equity counterparts. With just a slight move higher in the underlying, the properly selected option can jump significantly, on a percentage basis. Here's a simple example:

• Stock XYZ is trading at $60
• Stacy buys 100 shares for $6,000
• Adam buys the in-the-money, back-month XYZ 57.50 call for $3.50 ($350 per contract)
• XYZ rallies $4 to $64
• The XYZ call is worth $6.50 at expiration
• Stacy nets a profit of $400 on the stock (6.7%), while Adam nets a profit of $300 (85.7%) on the option

In this example, Adam's $350 controls the same 100 shares that Stacy's $6,000 does. Considering the reduced cost,  Adam could have bought additional contracts, which would improve his net dollar gain.

And while Stacy ties up $6,000 in a single stock, Adam could take the same amount of money and invest in multiple underlying issues by purchasing additional long calls (or puts). Now let's see what happens when the stock pick turns south:

• Stock XYZ is trading at $60
• Stacy buys 100 shares for $6,000
• Adam buys the in-the-money, back-month XYZ 57.50 call for $3.50 ($350 per contract)
• XYZ drops $3 to $57
• The XYZ call is worth $0 at expiration
• Stacy loses $300 (5%), Adam loses $350 (100%)

In this example, Adam loses his full investment, since his call expires out-of-the-money, while Stacy loses just $300 of her initial $6,000. But here's the key difference: if something catastrophic happens and XYZ were to drop by $10, $20, or even $40, Adam's loss on the option will never be more than the premium he paid for the call (minus commissions, of course), while Stacy's stock position is vulnerable, all the way down to zero.