What is the advantage of buying a stock option? why not just short sell or go long?

Question

I am still not understanding the advantages of options. It could also be becasue i do not have a complete understanding of options, but i have been reading everywhere and i havent found a place where they have explained it well enough. How does having an expiration help?

Thanks for all the help!

Answer 1

if you're long the option, the expiration doesn't help. however, if you're short the option, it saves your butt by limiting risk.



the benefit of being long options is implied leverage. let's say XYZ is trading at $37.50. you have a price target of $45, and expect XYZ to reach that target by Jan. 2009. You can buy a Jan 09 $40 call for $1.25.



If you want to maximize your returns, why shell out $37.50 for the stock when you could buy 30x as many shares for the same amount of capital?



If you bought 100 shares of XYZ at $37.50, it would cost you $3,750. If your prediction was right, you would have a gain of $7.50/share, or $750. If you used that same $3,750 of capital to buy the calls, you could control 3,000 shares. If your prediction was right, then you would have a profit of (45-40=5 -> 5-1.25=3.75) $3.75/share, for 3,000 shares! here, you would profit $11,250.



So the implied leverage of the option would take your profit from $750 to $11,250. that's a marginal gain of $10,500. the return on investment would go from (750/3750) 20% to 3,000%.



options are high risk/high reward instruments. this is attractive to investors with limited access to capital, or margin.

Answer 2

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There are several potential advantages to buying a stock option. Other answers have listed two advantages.



(1) You decrease the number of dollars at risk per share.



While that is a true statement, it is equally true that your chance of losing 100% of what you paid is much higher. To me that offsets the decrease in the number of dollars at risk.



(2) You get more leverage with options, so an amount invested in a stock option can make more dollars than the same amount invested in the stock itself.



That is also a true statement, but if you invest the same amount in a stock option as you would have invested in the stock you have eliminated the first advantage listed. Now you can lose the same amount af money but you will lose the entire amount more often with an option than with the stock. Furthermore, leverage is a two edged sword. While you make more money when you are right, you will almost certainly lose move money when you are wrong. That means leverage is only a good thing if you are much better than average in making good picks.



I hope it is clear that I find those two advantages dubious.



(3) The big advantage that I see in trading options is that options provide you a way to trade volatility. You want to buy an option when you believe the implied volatility of the option is too low because the price of the option will increase with any increase in implied volatility. (If you are not familiar with implied volatility, or IV, it is effectively the consensus estimate of the volatility the stock will see prior to expiration of the options.)



(4) Another advantage I see in buying an option is to hedge another position. If the other position is a long stock position that would mean buying a put option to protect it. For a short stock position that would mean buying a protective call option.



(5) The last advatage I will mention is that you can sometimes take an option position when you cannot take an equivalent stock position. This is particularly true when your broker does not have any shares available to be shorted.



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Two excellent free sites for education are



http://www.cboe.com/LearnCenter/default.aspx



and



http://www.optionseducation.org/



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The only way having an expiration date helps the buyer is that it keeps the price of the option down. With the exception of deep in the money European-stype put options, an option with less time until expiration will always have a lower price than an otherwise identical option with more time until expiration. As others have mentioned, the expiration date helps the seller more than the buyer.



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I realize I have not fully explained the concept of trading volatility. Quite simply, it would take too much space. There are excellent books available on the subject, such as "Option Volatility & Pricing" by Sheldon Natenberg if you want to learn more about it.

Answer 3

Having an expiration helps the one who is selling options. Because if the option expires worthless. Then whoever sold the option keeps all the proceeds of his sale.



For the buyer of options the main advantage is leverage. For a relatively small amount of money you can buy some stock options. And within a short time, you can double or triple your money.



Of course, the risk of loosing your money is correlated with how much money you can make. And this is true with options too. If the stock prices don't go your way before the expiration date. Then you can loose 100% of your investment.



If you simply go long or short on stocks. Then it's very unlikely that you will double or triple your money within a short time. But it's also unlikely that you will loose 100% of your investment.



Stock trading is less risky that options trading is. But the amount of money you can make from stock trading is also less.

Answer 4

Difficult question to answer briefly. Basically, options are just a different financial instrument. The ways of trading them are quite different from buying and selling stock. It is a mistake in most cases to just buy a call because you think the price of the stock is going up, for example. If the only thing you're considering is price direction, much better to just buy the stock. But by buying options you can get much more leverage for fewer dollars, so people buy calls instead of buying stock. In most cases, they end up regretting it.



The way professionals deal with options is to identify underpriced/overpriced options, and buy the underpriced ones, and sell the overpriced ones. An option's price is really a function of 3 terms, (1) the relation of strike price to current stock price, (2) time to expiration, and (3) the volatility of the stock. By punching these numbers into a pricing model, such as the Black-Scholes model, you can come up with a theoretically 'correct' price for the option. If the actual price is significantly different, there may be an opportunity for profit. Buy the option which is cheaper than its theoretical price and sell it when it reverts towards its correct price, rising in value. There are some extremely complex ways of doing this, called 'delta hedging.' But for small investors it's not realistically possible to delta hedge.



Options are fascinating because there are SO many ways to create positions, compared with just two for stocks (long/short). One reasonable way to add options to your repertoire is selling covered calls. If you're long some stock, and options are sold on that stock, you can sell a certain number of calls (strike price above the current stock price) without incurring much risk. If the price of the stock does not reach the strike price by expiration, you get to keep the premium you received for selling the calls. Then you can repeat that process again and again.



If you want to buy calls simply as an alternative to buying the stock, choose options that are farther out from expiration (in answer to your question, having an expiration date NEVER helps the buyer of options, only the seller), and be realistic about how far the price of the stock could reasonable move in that time. Swinging for home runs on deeply out of the money options will result in a 99% failure rate. You'll probably run out of money before you hit the home run.

Answer 5

Buying a call option would have a different stock price speculation than short selling. If you speculate the price will rise, then you buy a call option which allows you to buy shares of a stock at a specified price (thus when the stock price goes up you're buying shares at less than market price). A call option is less risky than buying the stock itself, because if the option is "out of the money" and worthless all you lose is what you paid for the option (typically a low sum of money), however, if you bought the stock speculating a rise in the stock price you can lose up to your total investment in that stock (which in all cases is a lot more money than you would have paid for the call option.)



Short selling would be that you speculate the stock price is going to fall. You sell "someone else's shares" that they are sitting on, then you buy them back after the stock price has fallen. In simple terms, your gain is coming at someone else's loss.



Additionally, a put option allows you to sell shares at a specified price.



I'm not sure what you mean by go long, because to me that typically means buying a normal call or put option. If it helps, I'm from the US, because I believe some European countries use different terminology.

Answer 6

You buy a call option for the right to buy a share of stock within some time limit at a strike price.



The price of the option is only a fraction of the price of the actual stock.

The price you paid is the maximum amount you can lose.



The price is base on a number of factors, part of that is time so the longer the expiration the more it will cost. This is because there is more time for you to be right.



.

Answer 7

stock costs 100/share - you have options to buy at 60, options themselves are $300/100 shares - to just buy 100 shares on the open mkt, you would need $10,000 plus sales commission. options have $37 profit per share built in (purchase price of 60 plus the $3 option cost per share) - you can "exercise" them buy buying the shares from the company directly at 60 and selling for 100 and you usually don't have to actually have the $6000 on you, and then you get your $4000 profit (less commissions) - or since the options are worth $37 per share = you can sell the option to anyone for say $30 a share - get $3000 right away and they can turn around and exercise them and immediateey make a profit

Answer 8

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Answer 9

you can buy an option without actually buying a stock, lessening the risk