Buying Stock Using Stock Options
Stock options are a viable addition to some investors' portfolios
When long-term investors want to invest in a stock, they usually buy the stock at the current market price and pay full price for the stock. One alternative to paying the full price at purchase is to buy it using margin. Basically, this is a 2:1 loan from your brokerage, allowing you, for example, to buy $1,500 worth of stock with an investment of only $500.00
Another way to buy stock without investing the full amount of the purchase at the point of sale is to use stock options. Buying stock options allows you to leverage your purchases far more than is possible in even a margined stock purchase.
Stock Options Defined
A stock option is a contract giving you the right, but not the obligation, to buy or sell an equity, usually a single stock, at a specified price. Options are time-limited, although the limits vary widely. If you do not exercise your right before the expiration date, your option expires and you lose the entire amount of your investment.
Stock options can be used to trade a stock for the short term or to invest for a longer term. Since all options are time-limited, however, most options are used in the execution of a shorter-term trading strategy. Stock options are available on most individual stocks in the US, Europe, and Asia. Note that in contrast to the 2:1 leverage of margin trading in the stock market, options trading effectively leverages your investments at dramatically higher ratios. This allows you to control a large amount of assets with only a small investment.
It also dramatically increases your risk.
Many different kinds of options contracts exist. The following is one example using an out-of-the-money put option. The following strategy involves selling put options on a stock without actually owning the underlying shares. Beginning traders and newer investors may not have access to this capability within their trading platform.
Buying Stock Using Puts
When using stock options to invest in a particular stock, the reasons for investing in the options may be the same as when buying the actual stock. Once a suitable stock has been chosen, one common type of options trade is executed as follows:
- Sell one out of the money put option for every 100 shares of stock
- Wait for the stock price to decrease to the put options' strike price
- If the options are assigned (by the exchange), buy the underlying stock at the strike price
- If the options are not assigned, keep the premium received for the put options as profit
Advantages of Options
There are three main advantages of using this stock options strategy to buy stock.
- When put options are initially sold, the trader immediately receives the price of the put options as profit. If the underlying stock price never decreases to the put options' strike price, the trader never buys the stock and keeps the profit from the put options.
- If the underlying stock price decreases to the put options' strike price, the trader can buy the stock at the strike price, rather than at the previously higher market price. As the trader chooses which put options to sell, she can choose the strike price, and therefore have some measure of control over the price she pays for the stock.
- Because the trader receives the price of the put options as profit, this provides a small buffer between the purchase price of the stock and the breakeven point of the trade. This buffer means that the stock price has a slight cushion before the price decline results in a loss.
A Detailed Example Trade
A long-term stock investor has decided to invest in XYZ company. XYZ's stock is currently trading at $430, and the next options expiration is one month away. The investor wants to purchase 1,000 shares of XYZ, so they execute the following stock options trade:
Sell 10 naked put options (each options contract is worth 100 shares), with a strike price of $420, at a price of $7 per options contract. The put options are "naked" because the investor does not currently own the underlying stock. The total amount received for this trade is $7,000 (calculated at $7 x 100 x 10 = $7,000). The investor receives the $7,000 immediately and keeps this as profit.
The investor waits for XYZ's stock price to decrease to the put options' strike price of $420. If the stock price decreases to $420, the put options will be exercised, and the put options may be assigned by the exchange. If the put options are assigned, the investor will purchase XYZ's stock at $420 per share, which is the strike price that he originally chose when he sold the puts.
If the puts are exercised and the investor does have to buy the underlying stock, the $7,000 received for the put options will create a small buffer against his stock investment becoming a loss. The buffer will be $7 per share (calculated as $7,000 / 1000 = $7). This means that the investor will break even at a stock price of $413, otherwise, the stock investment becomes a loss.
If XYZ's stock price does not decrease to the put options' strike price of $420, the put options will not be exercised, so the investor will not buy the underlying stock. Instead, the investor keeps the $7,000 received for the put options as profit.
Options have other uses beyond the scope of this article. In several investment situations, it might make sense to invest in options rather than the underlying stock. Note, however, that the basic fact of options trading, that you are highly leveraging your investment, inevitably means your investment risk is also substantially increased.