Boosting Returns With Options
Options offer leverage and a chance to make big percentage gains in a relatively short amount of time. Because options have lower prices than the underlying stock, their percentage movements tend to be much greater.
A $1 move in a $50 stock is only a 2% move. But in a $2 option, a $1 move is a 50% difference.
In addition, with the same amount of money, you can buy more options than you could buy stocks. It’s no surprise then that options are popular for aggressive traders looking to maximize gains.
Of course, on the flip side, if you are wrong and the stock moves against you, the option will lose more in percentage terms. It can even fall to zero.
Thus, leverage can work for or against you. However, losing a bigger percentage doesn’t mean losing more money. This is because when you buy an option, you usually invest a smaller amount unless you really want to go for a home run.
Example With SNAP
Let’s say you really like Snap Inc. (NYSE: SNAP). You think it will rise in the next year and you want to buy 200 shares. As of this writing, SNAP is trading for about $49, so you would need about $9,800 to purchase 200 shares.
If you use options instead, you could buy 2 contracts of the SNAP April 14, 2022 $55 calls for about $3.65 each. (Remember that one option contract is equal to 100 shares of the underlying stock.) This means if you invested $730 ($3.65x2x100), you would own two contracts, the right to purchase 200 shares of SNAP at $55 at any time before the option expires. Obviously, unless the stock goes above $55, it would make no sense to exercise the option.
No matters what happens, you won’t lose more than $730, the premium you paid. However, if the stock takes off, your upside in the call option is as high as the stock will go.
Percentage vs. Dollars
Because the original starting amount is so much bigger when you buy the stock, even if you lost 10% of the original $9,800, you would lose more ($980) than if you lost 100% of your $730 investment in the SNAP call option.
Now, the opposite also holds true. If SNAP moves in your favor, even though your percentage gain may be much greater, your dollar gain may not be as big. You will need more than double to match a 10% gain in the stock.
Let’s say SNAP ends up at $65 on expiration date. If you bought 200 shares of SNAP at $49, your percentage gain would be 32.7% and your dollar gain would be $3,200 ($16×200).
If you held the April 2022 calls and sold them right before expiration, each contract would be priced at about $10. Since each contract is equivalent to 100 shares of the stock, that means the position is worth about $2,000. Your gain would be about $1,270 ($2,000-$730).
In percentage terms, that’s a 174% gain, but clearly in dollar terms, it’s a smaller profit. However, the beauty is that with an option you only risked $730 to make the $1,270 profit.
Time Is Your Enemy
The drawback to options is that they expire. Thus, you only have a finite amount of time for the underlying stock to move in your favor. As expiration approaches, time decay accelerates and the value of the option goes down faster.
In the SNAP example I gave above, the option has a life of a bit under four months. You could instead buy a longer-date call though. In exchange, you will have to pay a higher premium. Even if a higher premium, though, it will cost less in dollars than buying the stock outright.
Consider a LEAP
If you are interested in the maximum long-dated option available, you can seek out LEAP (long term equity anticipation) options. These are available for up to three years in the future and they always expire in January.
When you buy an option instead of the stock, you won’t be able to collect dividends since you are not a shareholder. However, if you are interested in options, you are looking for capital gains, not a dividend stream, so that shouldn’t be a big deal.
Options trading can be quite lucrative, but as my article just showed, it can also be complex. One of the smartest options traders I know is my colleague, Jim Fink. Are you looking for fast growth, with less risk? Consider tapping Jim’s expertise. He has a way of making it all seem simple.
As chief investment strategist of the premium trading service Velocity Trader, Jim Fink has devised options investing methodologies that make money in up or down markets, in good times or bad.
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