Trading Options vs. Stock: How Do You Choose?
The Big Question
The decision between investing in options vs. stock is a question that most investors have trouble answering with any confidence. In this lesson, I'll show you the difference between the two types of investments using AAPL as an example. You'll get to see leverage and risk-reward analysis in action. But more importantly, this lesson highlights what the industry doesn't teach you and why.
Let's start by looking at a typical situation in the market.
Here is a chart of Apple (AAPL):
With disappointing earnings and an overall market that was falling precipitously, AAPL went from $230 in early October to $140 at the start of 2019. Almost a 40% drop!
However, by late February the market had found some footing and AAPL jumped back above $170. Today is February 26th and AAPL is $173.
The Set Up: AAPL Options vs. Stock
Let’s assume you thought this slide lower in 2018 was unwarranted. You want to buy 100 shares of stock because you think the stock will continue moving higher in the near future.
At $173, 100 shares of stock will cost you $17,300.
Or, you can use a Call Option.
AAPL Option Detail
Assume that you can buy 1 AAPL March 22nd $180 Call Option for $1.33.
From that detail, you know that this contract represents:
- 100 shares of AAPL (100 multiplier).
- It has an Expiration Date of March 22nd.
- A Strike Price of $180.
- Options Premium of $1.33 per contract. The total options premium that you need to pay upfront is $133 ($1.33 x 1 contract x 100 multiplier = $133).
Let's review what this means.
AAPL Option Explained
This 1 contract gives you the right to buy 100 AAPL shares on March 22nd for a price of $180, or a total outlay of $18,000. You can make that purchase no matter where the stock is at that time.
Remember, one of the benefits of buying an option is that there is no obligation to buy the stock for $180.
For example, if AAPL goes back down to $140, then obviously you won’t want to pay $180. In that case, your option will expire and your total loss would be the options premium paid ($133).
The second benefit of holding an option is the ability to sell the options contract at any time prior to March 22nd. This means you don’t have to hold the contract until the expiration date.
Just like you buy and sell a stock, you can buy and sell an option.
Comparing Both Scenarios
So, let’s take a look at our two scenarios on February 26th:
Scenario A: Buy 100 shares of AAPL for $173, or total outlay of $17,300. This gives you full exposure to the stock, up or down in price. You also get any dividends issued by AAPL.
Scenario B: Buy 1 AAPL Mar. 22nd $180 Call Option for $1.33, total outlay of $133. This gives you exposure to AAPL as it trades over the next 4 weeks and gives you the right to buy it at $180 until the Expiration date, Mar. 22nd.Now let’s take a look at what happened...
The Results: AAPL Options vs. Stock
You were right!
AAPL did move higher. In fact, it reached a high* of $196.19 on March 21st before settling down at $189.60 at expiration on March 22nd.
In order to do the options vs. stock analysis, I created a breakdown of Profits/Losses in dollars ($) and in percentage returns (%) for each day from Feb 26th to Mar 22nd:
Notice that the stock went up $23.19 from $173 to $196.19 at the highs on March 21st. A sale there would have been a profit of $2,319, or +13.4%.
On the Expiration Date, March 22nd, the stock was up $16.60 for a profit of $1,660, or +9.6%.
Now, let’s look at how the $180 Call Options performed.
At $196.19 on March 21st, the $180 Calls were worth $16.19. And at $189.60 the next day, they were worth $9.60. The options profits at the highs were $1,486 ($1619 - $133), and $827 ($960-$133) at Expiration.
But if we look at the trades with percentages, it tells a different story.
The options scored a 1,117.3% return at the highs, and 621.8% at expiration. These are explosive returns in 4-weeks. And they’re well above the 13.4% and 9.6%, respectively, that you receive with stock. Yes, you make slightly less in total dollar profits, but you risked only a fraction of the capital used to buy stock.
What if AAPL Declined?
Let’s also take a look at the downside risk.
Assume that AAPL went down instead of up. And why couldn’t it, right?
If AAPL reversed back to $140 at Expiration, the option would be worth $0 and you would lose 100% of your initial investment. The loss would total $133.
On the other hand, the 100 shares would only lose 19.1%. But this 19.1% loss equates to a $3,300 loss! This is significantly higher than the $133 loss using options.
This example illustrated the decision between using options vs. stock with a trade idea. It revealed how options can be used to reduce the risk of a trade idea, while maximizing the potential reward. The example also showed you how leverage can work in your favor if used correctly.
But here's the issue... It skirts the real problem.
The question you must focus on is the following:
How and Why did I pick the AAPL March 22nd $180 Call Option?
Then, how did I know that was the right one?
Any available education skips that part and simply gives you the option like I just did in this example.
No education shows you why that option was the right one to pick.
In the next lesson, we will get into the heart of these answers and why everyone is confused.