What are the Benefits of Buying an Option Versus Owning Shares Its Stock?

Trader’s Edge

What are the Benefits of Buying an Option Versus Owning Shares of Stock?

By Wendy Kirkland

For right now, let’s not worry about whether we know for sure that a stock is ready to move up or down, for today’s discussion, we’ll say we know that the stock will report earnings the first of next week. With that knowledge, we are interested in trading that equity because we feel it will move up in price after its earnings report.  For this discussion, let’s pick an equity, any equity, it doesn’t matter.

Let’s use Salesforce.com (CRM). It is a good mover and is at a price that is easy to multiple.  Its current price is $250 per share.  So, as we mentioned, let’s say that we’d like to purchase shares of Salesforce.com (CRM) because we feel it will have a positive earnings report and will move up in price.  Likely by the end of the week, its price might be $255, and we will say we have $1,000 we’d like to invest.  This means we could buy 4 shares and spend $1,000.

It had its earnings last week on the 29th, but let’s pretend it is today – this is just an example). In the morning before open the report comes out and the report is above what was expected and price moves up $5 and continues to rise into the rest of the week, so by Friday, its price is $265.  It looks a little top heavy and because it is a Friday, you decide to sell to take profits.

You bought the 4 shares for $250 and sell for $265, realizing $15 profit per share or a $60 gain over that short 5-day period.  No real physical effort, just buy and then sell the stock.

Let’s compare the same stock and price movement, but let’s apply it to stock options.  I think of option trading as renting equities for a specific period of time.  On a brokerage’s website, they have option chains listed.  Chains list the prices of the options (Ask is what you normally pay to buy a specific strike option and Bid is what you normally receive when you sell.)

Below is an image of the 250 strike that expires on 12/15/23. For our trade example, we bought on the day of earnings the 29th of November which is the flat area close to the word “Sell”.  The Ask premium was $1.50 per share or $150 per contract.

 

 

The image above is an example of an option chart, showing the ask premium as price moves up and down.  We are just using this for our discussion to explain the process.

On the 29th, the day we decide to buy the options, the stock’s price is at $230 and we select the 250 strike ($20 out-of-the-money) because we feel before the expiration date of the option, November 15th, price will rise up to $250 or beyond.  We will have access to the option contracts for a little over two weeks and will benefit from price gains or lose value, if price drops for as long as we hold during that time period. We can sell anytime during that period.

We paid the Ask of $1.50 for the 250 strike. This totals $275 per contract of 100 shares. We buy 4 contracts for $1,000.  We now benefit from or will lose based on 400 shares of CRM. After earnings, the Ask goes up and it continues to rise for two days when we choose to sell to close the trade when price start to ease down.  In a sense, what we have done is to rent the stock for a period of time, about two weeks.  That said, we decide to close the trade well ahead of expiration and stop renting after three days.  When we close the option trade, it still has time value as well as price value. We receive the current Bid price (the difference between the Ask/Bid is like commission to the one handling the trade/rental.) 

When we close the trade, we receive $14.20 per share.  Each contract is now valued at $1,420 because each contract covers 100 shares of stock, and we purchased 4 contracts or received a total of $5,680.  We paid $1,000 and sold for $5,680, meaning we gained or earned a profit of $4,680 or 468% gain over those 3 days.  Not bad!

This example shares the benefit of trading options or renting stocks for a specific period of time.  When you buy a share of stock, you own it until you sell. There is no time limit. You could hold it for years.  When you trade options, you select and pay for an expiration date.  It could be a day, a week, months, or years.  The more time, the more expensive.  Once you learn to interpret charts and their patterns, you then decide based on some factor (earnings, news, chart patterns), what strike to select, Ask premium to pay and what you expect to happen during that time-span.  When it happens, you sell to close the trade. If the move doesn’t happen, you close to protect from a large loss.

Trading options provides leverage. In our example, 4-contracts means you benefited from the price move of 400 shares of Salesforce.com, not just 4 shares, for about the same investment. (A little more, but close.)

Again, option trading is like renting equities for a specific period of time, so the next step is to learn how to interpret charts so you know what is likely to happen next with price, so you can jump in.

Another unusual aspect of option trading is that you can earn money on an equity’s price move even if it drops in value.  Next month we will discuss Put options (options to choose when you expect price to drop.)

My goal is to teach everyday people how to trade options, to learn to read charts, and while they are learning, they can participte in a program like ALPHA that trades the daily charts of equities like Salesforce.com (CRM).  I think of this as an earn-while-you-learn program that is perfectly suited for people who are interested in learning to trade options as well as have the opportunity to earn a profit as part of the learning process.

Have a terrific weekend.

 

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