On August 26, I wrote a little about stop loss orders and their use
and shortcomings. This weekend, I want to discuss some uses of options
to try to reduce risk. Brokers will tell you and the literature is full
of statements that *options are risky*. Indeed, they can be. How about
buying a stock -- is that risky? You bet (often quite literally). When
I buy a stock and do nothing else, my risk is what I paid for the stock.
Obviously, if I buy a stock, I control the stock in the sense that
I can keep it or sell it. Is there any other way I can control a stock
without risking the whole price of the stock? What if I buy a call
option? Remember from several articles back that the buyer of a call
option obtains the right, but does not have the obligation to buy the
stock at the strike price anytime before expiration. Let's look at a
concrete example comparing the purchase of shares of stock to buying
call options on the same stock.
For example, as I write this in mid-August, one of the Dow
components, duPont (DD) is trading just below $40. If I were bullish on
DD (and I don't mean to indicate that I am at the moment), I could
certainly buy the stock at $40. Suppose I bought 1000 shares at $40.
That would require $40,000 ($20,000 if I bought on margin) and I would
have $40,000 at risk. Suppose, instead, I decided to buy the Jan '08
LEAPS 40 calls. As I write, they are trading at $3.90 x $4.10. If I
bought 10 contracts (remember a contract controls 100 shares), I would
obtain the right to buy the stock anytime between now and expiration on
the third Friday in January, 2008 at $40 a share. See how I would now
be controlling 1000 shares until expiration. No matter what the stock
price, if I chose, I could buy the stock at $40. Even if the stock went
to $300 or $500 a share, I could buy it for $40. What would it cost me
to control the stock by buying the Jan '08 40 call? Well, the ask price
is $4.10 so I could buy 10 contracts for $4,100 (10 contracts x 100
shares per contract x $4.10 a share). Let's say I was right about the
direction of DD and it went to $70 by expiration in Jan 2008. What would
my calls be worth then? Well, I could exercise my option and buy the
stock for $40 a share and immediately turn around and sell it for $70 so
I'd make $30 a share x my 1000 shares or $30,000 (less commissions). My
initial investment was $4,100 so the profit before commission would be
$25,900 ($30,000 - $4,100) or a return of 631%. Of course, if I bought
the stock instead of the call, I would also have made $30,000, but on an
investment of $40,000 so my before commission return would only be 75%.
In our example, the stock went up. Suppose it stays the same or
goes down. If it stays at $40 until expiration and I bought the calls,
they will expire. Time will run out. If the stock is at $40 at
expiration, I will have lost my $4,100 if I just bought the calls. Of
course, if I bought the stock, I'd still own it and it would still be
worth the $40,000. What if the stock dropped to $30, though? Well, at
expiration, my options would not be worth anything and I would have lost
my initial $4,100 investment. However, had I bought and kept the stock,
I would be down $10,000.
From those scenarios, I hope you can see the relative advantages
and disadvantages of call ownership and stock ownership. I should also
note that many novice option traders think they need to hold onto their
options until expiration. That is not the case. Options can and
frequently are traded throughout their life. In our DD example above,
suppose the stock dipped below a support two months after buying the
option and suppose the option was then trading for $3.10 x $3.60. In
that case, I could sell my option for $3.10 and suffer a $1.00 per share
loss. Or, suppose DD ran up to $55 in a couple of weeks and the '08 $40
call was then trading at $16.10. I could sell the option and take my
$12 a share profit right away.
As you analyze your own trades, always remember that options do
expire.
Good Trading!
Bill Kraft
Mr. Kraft's past articles are posted on our website for your review.
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