Trading Options Vs Stocks

Options provide you with leverage, which results in higher profit AND losses when compared to stocks. Let's do a quick comparison to see how the same investment amount, if invested in stocks Vs call options, will change when the stock price goes up, down or remains the same through expiration.

Lets assume the following Call options table for Stock A. Sample delta values included. Available at http://www.optionsxpress.com .

Percentage Change at the end of the day-> 4% Up
Option Chains table (CALL OPTIONS) for Stock A for the month of June - Expiration June 2013 (Expires on June 22, 2013)
Strike Price Symbol Direction Change Last BID ASK Delta VOL OPEN INT In/At/OutOfTheMoney
30 stocka12xx Up 3.50 6.19 5.39 5.59 0.99 2 100 In the money
31 stocka12xx Up 2.94 4.83 4.49 4.69 0.90 2 23 In the money
32 stocka12xx 0.00 3.90 3.69 3.89 0.80 12 24 In the money
33 stocka12xx Up 1.58 3.10 2.99 3.19 0.70 2 5 In the money
34 stocka12xx Up 0.90 2.45 2.34 2.44 0.60 3 20 In the money
35 stocka12xx Up 0.77 1.86 1.79 1.89 0.50 4048 45 At the money
36 stocka12xx Up 0.84 1.34 1.29 1.39 0.40 154 14 Out of the money
37 stocka12xx Up 0.50 1.04 0.89 1.00 0.30 18 274 Out of the money
38 stocka12xx Up 0.50 0.64 0.59 0.69 0.20 303 780 Out of the money
39 stocka12xx Up 0.44 0.44 0.39 0.49 0.10 109 244 Out of the money
40 stocka12xx Up 0.22 0.32 0.24 0.34 0.01 22 5317 Out of the money

Let's try to understand the column Delta. This implies, theoretically, how fast the option price will change for a corresponding change in the underlying stock. For instance, a delta of $0.60 for strike price 34 implies that for $1 increase in stock price, the option premium should increase by approx $0.60.

Before we calculate how many call option contracts you can buy with $2800, you need to know the following:
  • You buy and sell options in Number of Contracts
  • 1 option contract = 100 shares
  • Ask column shows Call option price of buying 1 share. Multiply by 100 to get total cost of buying 1 call option contract(100 shares)
  • Bid column shows Call option price of selling 1 share. Multiply by 100 to get total sales value of 1 call option contract

With this information lets proceed:
Current Stock Price: $35
Number of Stocks: If you were to invest $2800 in stocks, you would buy 80 shares(2800/35) of Stock A.
Number of Options: With $2800, if you choose Strike $34 with Expiration June 2013, you will be able to buy 11 call option contracts using the logic below:

Buying 1 contract at strike 34 call option costs (Ask price *100) = 2.44*100 = $244
Since you have $2800 to invest, you can buy approx 2800/244 = 11 Call option contracts

Cost of 11 call option contracts is actually
= Call Option Price + $8(commission for 1 trade) + 0.75*11(commission for 11 contracts. assuming $0.75 per contract)
= 11* 244 + 8 + 8.25
= 2684 + 8 + 8.25
= $2700.25 ($100 short-but close to $2800)

Recap:
Available Investment Amount= $2800
Stock: 80 shares at $35 each= $2800
Call Options: 11 call option contracts at strike $34 for Expiration June 2013 = $2700.25

Lets see what happens when the stock price increases, decreases or stays neutral through expiration date.
Strike Price Symbol Direction Change Last BID ASK Delta VOL OPEN INT In/At/OutOfTheMoney
34 stocka12xx Up 0.90 2.45 2.34 2.44 0.60 3 20 In the money


SCENARIO 1 - $35 STOCK PRICE INCREASES BY 25% TO $43.75
Stocks: Your 80 shares($2800 investment) will now be worth : 80 * 43.75 = $3500 (stock price increase of $8.75 = $43.75 - $35.00) or a profit of approx $700($3500 - $2800 - $8 trading cost) or a 25% profit

Call Options: Since the Delta is 0.60 for $34 strike Expiration June 2013, an increase of $8.75 in the stock price means that the option price will increase by approx 60% of the stock price increase or approx $8.75*0.60 = $5.25. The actual increase might be slightly different. Let's assume $4.00.
The Bid price at which we can sell 1 option contract will increase from $2.34 to approx $6.34(2.34 + 4).

Your 11 call option contracts can now be sold at
= (Bid price * 100 * 11) - $8(commission for 1 trade) - 0.75*11(commission for 11 contracts)
= (6.34 * 100 * 11) - 8 - 8.25
= $6,957 (or a profit of 6957 - 2700.25 = $4257) OR a 4257/2700*100 = 157% profit

Stocks Call Options Comments
Investment Amount $2800 $2700
Stock price increases by 25% Stock price increases by 25%
Final Investment Amount $3500 $6957
Profit $ $700 $4257
Profit % 25% 157% 6 times(157/25) MORE PROFIT using Options!


SCENARIO 2 - $35 STOCK PRICE DECREASES BY 5% TO $33.23
Stocks: Your 80 shares($2800 investment) will now be worth: 80 * 33.25 = $2660 or a loss of approx $132(2800- 2660 -8) or a 5% loss
Call Options: Using 0.6 Delta. The decrease of $1.75(35-33.25) means the option price should decrease by 60% of the stock price decrease or approx $1.75*0.60 = $1.05. The actual price decrease might be slightly different but this gives us a good estimation. Let's assume that the actual bid price falls by $0.8. which implies a new Bid price of 2.34 - 0.80 = 1.54
Your 11 call option contracts can now be sold at
= (Bid price * 100 * 11) - $8(commission for 1 trade) - 0.75*11(commission for 11 contracts)
= (1.54 * 100 * 11) - 8 - 8.25
= $1,694 (or a loss of $2700 - $1694 = $1006) OR 1006/2700*100 = 37% loss


Stocks Call Options Comments
Investment Amount $2800 $2700
Stock price decreases by 5% Stock price decreases by 5%
Final Investment Amount $2660 $1694
Loss $ ($132) ($1006)
Loss % (5%) (37%) 7 times(37/5) MORE LOSS using Options!


SCENARIO 3 - $35 STOCK PRICE DECREASES BY 25% TO $26.25
Stocks: Your 80 shares($2800 investment) will now be worth: 80 * 26.25 = $2100 or a loss of approx $700(2800- 2100 -8) or a 25% loss
Call Options: Using 0.6 Delta. The decrease of $8.75(35-26.25) means the option price will decrease by 60% of the stock price decrease or $8.75*0.60 = $5.25 which implies a new Bid price of 2.34 - 5.25 = (2.91) Since you cannot really sell at a negative price your option investment is basically worthless or $0. This also brings up another point-that the maximum amount that you can lose is all your initial investment and nothing more($2700). This equates to a loss of 100%.

Stocks Call Options Comments
Investment Amount $2800 $2700
Stock price decreases by 25% Stock price decreases by 25%
Final Investment Amount $2100 $0
Loss $ ($700) ($2700)
Loss % (25%) (100%) Options lost all their value!


SCENARIO 4 - STOCK PRICE STAYS THE SAME AS $35 ALL THE WAY THROUGH EXPIRATION DATE
Days before Expiration 90 days 60 days 30 days ExpirationDate Comments
Option Price $2.34 $1.94 $1.37 $0 stock price $35 > strike price 34 at Expiration = Out of the Money
11 Call Option Investment Value
(11*optionprice*100)
$2574 $2134 $1507 $0 stock price $35 > strike price 34 at Expiration = Out of the Money
Stock Investment value $2800 $2800 $2800 $2800

As you can see even if the stock remains flat, the option investment keep on losing their value . Going from 90 to 60 days decreased 17% of the investment value. Going from 60 to 30 days decreased 29% of the investment value and going from 30 days to expiration rendered the call option worthless(loss of 100%), meaning your option Investment value went down to $0.


SCENARIO SUMMARY
Stocks Call Options Comments
Stock Price Increases by 25% 25% Increase 157% increase 6 times MORE PROFIT using Options!
Stock price decreases by 5% 5% Decrease 37% decrease 7 times MORE LOSS using Options!
Stock price decreases by 25% 25% Decrease 100% decrease Options decrease in value to $0!
Stock price stays the same through Expiration Same value throughout Out of money options continuously decrease in value all the way to $0


NOTE
The scenario examples above are rough approximations and are just intended to provide you with a general understanding of the leveraged nature of options and an insight to option mechanics(delta, calculations, bid/ask etc.). The actual call options increase/decrease for the related stock price change will most likely be different!




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