We've been talking recently about the advantages of options
trading over stock trading. The main advantages are that you put
fewer dollars at risk, and that you can take advantage of leverage.
But there are other good reasons to consider options trading.
Downside risk is limited in many option
By way of example, let's take a look at options on the
ever-popular ABC Co. (
). Say ABC closed Thursday at $48.50. By comparison, ABC's
near-the-money June 50 call costs $2.
Let's say that Jill Trader purchases 100 shares at $48.50 for a
total cash outlay of $4,850. Meanwhile, Susie Speculator buys to
open one June 50 call for a total outlay of $200 ($2.00 x 100
shares per contract). Unfortunately, Jill and Susie are not very
good prognosticators. ABC shares plunge during the next several
weeks, and by the time June-dated options expire, they're wallowing
at $33 per share.
Our hypothetical investors have a very different reaction to the
stock's slide. Jill Trader is panicking, because she's already lost
$1,550 on paper -- and the decline doesn't show any signs of
slowing. She's faced with the choice of swallowing a big loss, or
waiting it out and hoping the shares turns around.
Elsewhere, Susie's disappointed, but not devastated. She simply
allows her out-of-the-money call to expire worthless, which means
that her total loss on the trade amounts to no more than her
initial investment of $200. It's not her best trading result ever,
but it's definitely a more palatable outcome than Jill's.
Feel free to stop caring about price/earnings
Let's talk fundamentals. Or rather, let's not.
Now, if you're used to investing in stocks, you're no doubt
accustomed to researching the price/earnings ratio, price/book
ratio, price/sales ratio... the list goes on. These metrics offer
clues as to whether a stock is overvalued or undervalued at current
levels, and many traders will analyze these fundamentals before
entering a position.
throw these fundamentals out the window
when trading options. The fact is, these metrics simply don't
matter as much to an option trader as they do to a buy-and-hold
Thanks to your lowered initial investment, as well as the magic
of leverage, you have a simple goal when you buy a call option. You
want the share price to rise above the strike price prior to
expiration, allowing you to collect your profit and exit the
So, since you're not investing in the company for the long run,
the traditional trading metrics shouldn't have much bearing on your
analysis. So what if ABC's price/earnings ratio of 19 is higher
than the average for its peer group? Even if the shares are
expensive now, you can still reap a profit as long as they're
expensive by the time your option expires.
Of course, fundamentals do play a part. If you're buying options
ahead of earnings, you should be aware that premiums might be
inflated by rising implied volatility. Or, if the pharmaceutical
firm that you're buying calls on is due to release trial data
within the next week, you should definitely have that event on your
But, beyond the basics, you can really stop sweating the
fundamentals. If you love crunching the numbers, though, don't
worry -- with put/call volume ratios, put/call open interest
ratios, and more, there are still plenty of metrics for an option
trader to play with.
Schaeffer's Investment Research Inc. offers real-time option
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Wealth-Building Techniques Using Equity & Index Options
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