Should you Invest in Stocks or Options?

The advantages of options
  • Options allow investors to speculate about the future direction of prices of stock through investment of a relatively small amount of money.
  • Investors can use options as insurance to hedge against great losses when adverse changes occur with stock prices.
  • Writing options provide investors of source of income.
  • Losses at buying options are limitations for the Premium amount

The disadvantages of options

  • Options are wasting assets due that they a short life span (up to nine months). LEAPS have a longer life span.
  • If the price of a stock did not get or reached above strike price the option investor loses money.
  • Although options can be used to generate profits of relatively high percentages through the small amounts invested, it has to take into account that commissions tend to be high on a percent basis.

Use of a combination of puts and calls
While investors turn sophisticated in the use of options, there are situations in which the combination of puts and calls can be combined to increase profit opportunities. A straddle is the buy or sell of a put and a call with similar strike price and the same expiration date, while a spread is the buy or sell of a combination of put and call options contracts with different strike prices.

Using a straddle
The following example illustrates how an investor can benefit using a straddle.

Let?s imagine that an investor is interested in buying some oil stocks. With a slow economy in Europe and Asia and the possibility that Iraq returns to the world oil market the investor is not very sure if prices will boost or fall with respect to current prices.

Consequently, instead of buying oil stocks, the investor could buy a combination of call and put option in an oil stock. Options in Exxon, whose stocks were being negotiated at $39 per share can be bought in the following way:

  • $ 2 3/8 ($237.50 per contract) for January call with a strike price of $40
  • $2 3/8 ($237.50 per contract)  for January put with a strike price of $40

The total cost of this straddle is of $475 ($237.50 + $237.50) plus commissions which means that the potential loss is limited to this amount if Exxon stock does not raise above $44 ? or below $35 ?  per share in the following six months before its expiration.

If oil prices raise, oil stocks could boost its prices significantly. Let?s suppose that prices of Exxon stock raise to $48 per share. A call option could be sold in almost $800 ($8 x 100 shares), resulting in a profit for the investor. On the other hand, Iraqi oil is introduced again to worldwide supply, causing a saturation of oil, prices of oil stocks could drop.

If the Exxon stock falls to $33 per share, the put option could be sold at around $7 per share, resulting in a profit when selling the option. If the Exxon stock is negotiated above $4.75 or below $35.25, the investor wins with the sale of the call or put options, respectively.

If Exxon is being negotiated within ranges between $ 35.25 and $44.75, the investor would lose money in the straddle. The loss amount will be subject to the Exxon stock price.

For example, if the investor sold the call option when Exxon was negotiating at $43.50, the option could have been sold in about $3.50 or $350 per contract. Then the loss would have been $125 (the cost of the straddle options $475 minus received proceeds of the sale of the option $350). Commissions increase losses even more.

To benefit from this straddle the price of the underlying stock must move considerably in one way or another, up or down.

Using a spread
Investors can use a spread strategy which is buying and selling different options with different strike prices and expiration date. For example, an investor could take both a long or a short position on two different options of the same stock.

There are a number of different spreads that can be used to hedge positions and that way limit potential losses and  profits. One can also use the Internet to gather information of the option prices to try his straddle and spread strategies before investing.