Here’s What Can Happen When Buying Option Contracts
Buying option contracts is typically a high-risk investment strategy that can pay off big. That’s because when things work right, you can buy an option contract cheaply, and sell it for a triple-digit return a short-time later.
The problem is, you may be just as likely to lose your entire investment when the option you buy expires.
Morris commented on a recent article, wondering about the business of buying option contracts:
Hi Zach, I always appreciate your reminders on “Here’s what can happen…”
Therefore, I would greatly appreciate knowing “what can happen” when buying calls and when buying puts. Even though you are in the “selling” game, not the buying game.
Morris R., retired
Thanks for the comment Morris. Let’s take a quick look at the details of buying option contracts…
Buying Option Contracts: You Must Get Direction AND Timing Right
The prospect of buying a option contracts is exciting for speculative investors because of the huge possible payout.
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Remember, a call option contract gives the owner the right to buy shares of stock at a specific price. If you own a put contract, you have the right to sell shares of stock at a specific price. Each contract represents 100 shares.
Imagine buying a cheap two-month option that gives you the right to buy shares of stock at $50. Let’s say the stock is currently trading at $45 and you pay $1.00 per share for that contract. Since the contract covers 100 shares, you’ll pay $100 to buy this contract.
If your stock trades from $45 to $55 in the next two months, the value of your option contract will increase to at least $5.00 per share. That’s because it’s worth $5.00 to be able to buy shares at $50 (which is your right) and sell them at $55.
Now you’re sitting on a 400% return. Nice!
On the other hand, if the underlying stock remains stable – or even if it “only” trades 10% higher to $49.50, your call contract will expire worthless. That means you’ll lose your entire investment — even if the stock moves 10% higher.
A 100% loss is very disappointing, especially if you invested a lot.
More importantly, your timing has to be exactly right when buying a option contracts. If the stock moves in your favor, but takes too long to do it, you still lose money.
There’s nothing more frustrating than being “right” about an investment, and still losing money on your trade.
Statistical Calculations When Buying Option Contracts
Buying option contracts can have big payoffs, as well as large percentage losses. So it’s important to balance your risk with potential return. Fortunately, you can use statistics to evaluate your option contracts.
Professional option traders often use “binomial” models when considering whether to buy option contracts. (These are simply models that assume one of two things will happen.)
Imagine that you own an option contract that will likely do one of two things:
- It might trade higher – giving you a 400% gain.
- It might expire worthless, giving you a 100% loss.
Now of course, this is an overly simple scenario. But the model helps us to better evaluate whether this option is worth buying.
The one additional piece of information we need at this point is:
- The probability of the 400% gain versus the 100% loss.
Let’s assume the option cost $1.00 and there is a 50% probability of each scenario.
This would be a great deal for investors. That’s because if you ran this scenario 10 times, you would make $2,000 for the five profitable instances. you would also lose $500 for the five negative instances. Altogether, statistics tell us that you can expect to make $1,500 in profit if you do this trade 10 times.
On the other hand, assume the option cost $1.00 and there is a 20% probability of the trade winning.
If you tried this scenario ten times you could expect to capture a gain of $800 from the two profitable instances. but you would lose $800 from the eight losing trades. Altogether this would not be a profitable scenario. Not to mention that you’re tying up your money that could have been earning a return somewhere else.
This is why it is so important to look at not just the large returns you can make buying option contracts, but the probability of your trade actually paying off.
Buying Option Contracts As An Insurance Policy
As a general rule, I’m not a fan of buying option contracts by themselves. But there is one exception to that rule.
Many times, I will buy a series of put contracts to help offset my exposure in case the market trades lower. This is like buying an “insurance policy” on my portfolio in case something bad happens.
When buying option contracts as a hedge (or insurance policy), there are two guidelines I follow:
- First, I buy put contracts on a index ETF like DIA (for the Dow Jones Industrial Average), SPY (for the S&P 500), or IWM (for the Russell 2000 Small Cap Index).
- Second, I buy longer-term put contracts — usually with six months or more until expiration.
Here’s why I use those two guidelines…
First, I’m offsetting the risk of the broad market trading lower. I’ve already done my research on dividend stocks that I own, or on company’s that I’ve sold puts against. So I’m not as worried about individual stock movements as I am about the broad market.
Second, I buy longer-term option contracts because these contracts lose value more slowly than short-term contracts.
This is important because I’m able to benefit from options losing value when I sell short-term puts on stocks that I want to own. But I get less detriment from options losing value when I buy long-term puts as an insurance policy.
As with all insurance policies, I hope I don’t have to use it. I’d rather lose money buying option contracts for insurance because that typically means I make more money from selling put contracts on stocks that I would like to own. (And I make more money from shares of stock that I am holding.)
So here’s my question…
Could you tell me about your experience buying option contracts? Have you had success? Have you learned anything from specific trades? How do you evaluate which options you will buy, and how do you determine when to exit your positions?
I’d love to hear from you!