Options provide a great way for traders and investors to realize the gain on equity movements without purchasing the underlying securities, yet only a small fraction of people utilize them in their own portfolios. Many traders and investors instead discount them as too complex and risky, when in many cases they can provide a superior risk/reward ratio over simply purchasing the underlying equity.
This article will explore these situations and detail how both traders and investors can use options as equity substitutes in order to multiply their portfolio gains while minimizing additional risk.
Options for the Investor
Options can provide investors with a great way to multiply profit while reducing risk in certain situations. Many tend to ignore options, however, simply because their value decays with time - a fact which seems to contradict the very principles of investing! There are, however, several instances where utilizing options instead of equity can substantially increase risk/reward over the long-term.
Long-Term Equity Anticipation Options (LEAPS)
LEAPS are long-term stock or index options that expire after more than nine months and sometimes as long as two years. They were first introduced by the Chicago Board of Trade in 1990 to enable investors to use options in their portfolios.
Let's quickly compare how purchasing LEAPS instead of stock can be beneficial for investors:
| Suppose an investor with a $10,000 portfolio wishes to purchase 100 shares of XYZ in January 2007, which were trading at $50 per share at the time the trade was placed. The investor has the following choices: purchase the stock outright, utilize 50% margin at a rate of 9% to purchase on margin, or purchase a LEAPS call expiring in Jan. 2008 with a strike price of $40 paying an option premium of $12.25. Let's then assume the stock rises 20% to $60 per share after one year. |
| -- | Using Stock | Using Stock w/Margin | Using Leaps |
| Cash Down | $5,000 | $2,500 | $1,325 |
| Borrow | $0 | $2,500 | $0 |
| Carry Cost* | $0 | $225 (9% over 1yr) | $220 (time premium) |
| Less Dividends | -$50 | -$50 | $0 |
| Net Carry Cost | -$50 | $175 | $220 |
| Risk | $5,000 | $5,000 | $1,325 |
| Net Profit | 21% | 33% | 59% |
* Carry costs are out of pocket expenses that investors pay on an investment, such as interest and incidental expenses.
This example, albeit simplistic, shows that while the carry cost and break-even point associated with LEAPS may be slightly higher, the overall risk is substantially lower. Now, the obvious risk is that LEAPS can expire worthless while stock always retains some of its value; however, the risk of LEAPS expiring worthless can be mitigated by purchasing them deep in the money. The further in the money the LEAPS are, the less likely that the price will move below the strike price causing them to expire worthless. This situation should be evaluated on a case-by-case basis.
LEAPS are also useful when betting on smaller price movements in safer stocks or indexes. For example, a 5% annual return on a normal stock may not seem like much for a traditional stock investor, but LEAPS can multiply that number to make it worthwhile. They are very popular for "expensive" stocks that tend to move less on a percentage basis than others.
In the end, LEAPS can occasionally provide investors with a more profitable and "safer" way to bet on long-term price movements without putting down all the capital necessary for purchasing the underlying stock. While they are certainly not perfect for every portfolio or situation, there are cases in which they can be effectively used to enhance returns while taking on minimal additional risk.
Options for the Trader
Options can also provide traders with an excellent way to multiply their profit while reducing their risk - and in some cases even reversing it! As an added bonus, options also take some of the emotion out of trades since there is less capital at stake and a more defined strategy.
Technical traders typically focus on either profiting from trading ranges or breakouts/breakdowns from these trading ranges. So, here are some strategies where options can be effectively used as equity substitutes in these situations:
Breakout Traders
Breakout traders take a substantial risk when they purchase a stock since these technical patterns are designed to predict impending volatility. The hope is that they can correctly predict the direction often enough to account for the increased risk. But what if there was a way to not only benefit more from a breakout in the direction you predict, but also offer protection in case you're wrong?
Backspreads offer the best solution for breakout traders by limiting potential losses while maintaining unlimited profit potential. In fact, if the price moves down enough, traders can even make a small profit on the trade. Keep in mind, however, that the potential loss lies in situations where the stock doesn't make a move in either direction - so make sure the breakout pattern is accurate.
Alternatively, breakout traders can use simple call or put options to straight bet without hedging. The key thing to remember when buying short-term options is to buy more time than you think you'll ever need! While you may predict a breakout over the next week, always allow some extra time for it to occur.
Trend Traders
Trend traders also take a risk when they purchase a stock since they are relying on the stock's trend to remain strong over the long-term. Any slowing of the trend can result in lost opportunity costs, while any reversal can turn a profit into a loss. But what if there was a way to multiply your gains on the upside while limiting your downside exposure?
One solution is the use of LEAPS. Long-term trend traders can benefit through the use of LEAPS in the same way that long-term investors do. These should only be used when traders are confident in the trend, however, as they can expire worthless if they drop below the strike price.
A surrogate covered call write is another solution for shorter-term trend traders who are neutral to bullish. Covered call writing enables traders to profit off of the premium, which is retained while the stock rises to the option's strike price. The obvious downside is a situation where the stock price declines, where traders are then stuck with a losing stock and a small premium. To solve this, the strategy uses LEAPS in lieu of actual stock in a covered call write in order to both better leverage your money and reduce risk.
Conclusion
Options can be the perfect substitute for equity in some cases, enabling traders and investors to multiply their returns and diversify their risks. They are certainly not perfect in every situation, however, and should be researched carefully before being used in practice.
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