Advantages and disadvantages of stock and call buying
Why buy calls when you can just buy the stock? It's an eternal debate plaguing many active investors, especially those contemplating a move into the derivatives market. But it is evident that more and more investors are supplementing their portfolios with options trading.
So, what are the key differences between a traditional long stock play and a long call? Let's start with a stock position's advantages. The main one is the dividend payout, in which option buyers do not partake.
Also, a stock trader is less likely to lose his or her total dollar investment than an option trader. But that total investment is typically bigger in terms of absolute dollars, and that's where the advantages of options come into play.
Options are attractive because of their low relative cost, which goes hand-in-hand with the leverage they provide compared to their equity counterparts. With just a slight move higher in the underlying, the properly selected option can jump significantly, on a percentage basis. It is easiest to illustrate this with an example.
- Stock XYZ is trading at $60
- Stacy buys 100 shares for $6,000
- Adam buys the in-the-money, back-month XYZ 57.50 call for $3.50 ($350 per contract)
- XYZ rallies $4 to $64
- The XYZ call is worth $6.50 at expiration
- Stacy nets a profit of $400 on the stock (6.7%), while Adam nets a profit of $300 (85.7%) on the option
In this example, Adam's $350 controls 100 shares of XYZ, just like Stacy's $6,000 investment in the stock itself. Adam could have bought additional contracts, which would improve his net dollar gain.
Additionally, while $6,000 of Stacy's money is tied up in one stock, Adam could take the same amount of money and invest in multiple underlying issues by purchasing additional long calls (or puts). Now let's see what happens when the stock pick turns south.
- Stock XYZ is trading at $60
- Stacy buys 100 shares for $6,000
- Adam buys the in-the-money, back-month XYZ 57.50 call for $3.50 ($350 per contract)
- XYZ drops $3 to $57
- The XYZ call is worth $0 at expiration
- Stacy loses $300 (5%), Adam loses $350 (100%)
In this example, Adam loses his full investment as his call expires out-of-the-money, while Stacy loses just $300 of her initial $6,000. But here's the difference: if something catastrophic happens and XYZ were to drop by $10, $20, or even $40, Adam's loss on the option will never be more than the premium he paid for the call (minus commissions, of course), while Stacy's stock position is vulnerable, theoretically, all the way down to the zero point.