Testimonials

May 27, 2011

To Buy Puts, or Not to Buy Puts…

Filed under: Options Education — Tags: , , , , — Dan Passarelli @ 3:20 pm

A lot of investors are enamored by the all mighty put – especially buying the shortest-term, or front month, put for protection. The problem, however, is that there is a flaw to the reasoning and practice of purchasing front-month puts as protection. Ah, yes; it’s true. Front-month contracts have a higher theta – and relying on front-month puts to protect a straight stock purchase is not, necessarily, the best way to protect an investment. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to by insurance.

Although front month options are often cheaper, they are not always your best bet. The reasoning may be sound, the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his position; but sound reasoning does not always lead to good practice. Let’s take a look at an example.

We will use a hypothetical trade today. The stock is trading a slightly above 13 and our hypothetical trader wants to own the stock because he/she thinks the stock will report blow-out earnings in each of the next two quarters. This investment will take at least six months, as the trader wants to allow the news events to push the stock higher.

Being a savvy options trader, our stock trader wants some insurance against a potential drop in the stock. The trader decides to buy a slightly out-of-the-money July 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That 0.50 premium represents almost 4 percent of the current stock price. In fact, if the investor rolled option month after month, it would put a big dent in the initial investment. To be sure, after about seven months (assuming the stock hangs around $13) the trader would lose more than 25 percent on the $13 investment.

What if the stock drops? That is the ultimate rationale for the strategy in the first place: protection. The put provides a hedge. The value of the option will increase as the stock drops, which counterbalances the loss suffered as the stock drops. Buying the put is a hedge, a veritable insurance policy – though, albeit, an expensive one. Investors can usually find better ways to protect a stock.

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May 12, 2011

Buying Call Options Rather Than Stock for GOOG

Filed under: Options Education — Tags: , , , , , — Dan Passarelli @ 10:50 am

You have your eye on a stock, a very high-valued stock like Google (NASDAQ: GOOG ). You believe that this stock, despite its high price, continues to have tremendous upside potential. The problem is that you don’t want to shell out $535 for one share of the search giant. What can you do to maximize your money and cash in on the perceived upside? Easy, buy a call option rather than the stock.

Quick Definition
For the uninitiated, a call option is a bullish strategy wherein a trader purchases the right (but not the obligation) to purchase a stock at a specified price within a specific time period. One advantage to buying a call option rather than purchasing a stock is that you can gain a much larger percentage return on your investment.

The Example
If you want to purchase 100 shares of GOOG stock at $535 it is going to cost you (100 X $535) $53,500.  However, let’s say that you decide to purchase 1 call option on GOOG (each option represents 100 shares) with a strike price of, say, 540 with a June expiration, which carries a price tag of $11.5. Rather than dishing out $53,500 for 100 GOOG stock shares, you instead pay $1,150 for the options – a rather nice difference of $51,850 that you can use for something else or to purchase other options.

The Money
The cost efficiency of purchasing call options can be far greater than simply purchasing shares of a stock, especially when you are dealing with high-priced stocks like GOOG. Remember that one option contract is the right to purchase 100 shares of a stock at that price. So, rather than purchasing 100 GOOG shares at $535 at the massive cost of (100 X $535) $53,500;  you have dished out a more reasonable $1,150 for the transaction. Of course, this is the scenario if you want to simply be bullish on GOOG stock.

Conclusion
As you can see, it is possible to lay out far less money to purchase call options on a stock that to by the call itself. In fact, the earlier the expiration you choose, the lower the price you could pay. No matter what math you use, paying $1,150 is far better than paying $53,500 for the same product. What if you want to sell these options to someone who is willing to pay a higher ask price than you paid? That is another subject for another time. Remember, there is no fool-proof way to make money in the market – there is risk involved in any trading strategy. One way to make sure you maximize your cash is to make sure you study your subject, remember that knowledge is power. Please check out our special Online Education deal for Options Blog readers.