Buying options as an investment strategy offers distinct advantages, primarily, more efficient use of ones' capital.
Two stand out advantages of buying options: Leverage and limited risk.
Typically, when a trader identifies a possible directional trade, a risk/reward analysisis made.
First, a determination of how much capital to commit to the trade (money management).
Next, an estimate is made of the potential gain if the trade is profitable. Then, an estimate is made of the potential risk involved if a stop-loss point is triggered andthe trade is "stopped out" (trade management).
These are, necessarily, "working" hypotheses because when working with "stop orders"nothing is "etched in granite".
If the potential reward compares favorably to the amount at risk (at least 3:1, at aminimum) the order is entered.
However, buying options, rather than positioning the underlying stock, to facilitate the trade can not only improve the risk/reward ratio due to the option leverage, therisk is no longer an estimate but a definite known quantity. A desirable feature, tobe sure.
Other advantages are the avoidance of margin debt interest expense, in the case of using call options as a substitute for buying stock, and the total avoidance of owing dividends, the "hassle" of borrowing stock, and no "up tick" rule, in the case of using put options as a substitute for selling stock short.
And the total avoidance of margin calls in either case.
In buying options, one does pay for "time" value. Time value is highest with at-the-moneyoptions. This can be reduced by positioning options that are in-the-money.
In-the-money options more correlate with or "track" the value of the underlying stock.The deeper in the money, the higher the correlation.
This correlation relationship also provides another advantage when buying options versuspositioning stock.
If the option starts off two strikes in-the-money and the stock price moves against yourposition, while you lose back "intrinsic" value you should also gain back "time" valueas the option moves closer to being at-the-money, thereby mitigating your loss.
For instance, a stock selling for $19.38 has in-the-money $17.50 calls available with 5 months time remaining trading at $2.70. That computes to $1.88 intrinsic value plus $.82 time value.
Also available are out-of-the-money $20.00 calls with the same amount of time remaining trading at $1.15, all time value.
Which is the better buy? The lower priced, more leveraged, out-of-the-money or the higherpriced, less leveraged, in-the-money?
The answer depends upon how high the trader thinks the stock will go.
The $17.50 calls cost more but already have a head start and are closer to break-even.Once passed break-even, the leverage kicks in.
The $20.00 calls are further away from their break-even but, once passed that point the leverage is also greater.
You tell me where the stock will go and I'll tell you what the better buy is.
The down side risk is limited in either case. The total potential loss is probably not greater than the planned stop-loss point would be. The "whip-saw" risk is completelyeliminated and the capital outlay is much less. The excess capital can rest securelyin U. S. Treasury bills earning interest.
The potential also exists for the trader to be able to engage in additional tradingstrategies, such as "legging" into vertical or diagonal spreads,if the traders' outlook should change.
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