Trading options vs. the underlying as an investment strategy

Which do you prefer to trade individual stocks or options on stocks? Each has its strengths and weaknesses. But before you answer, ask yourself if you have really been getting the most out of your option trades? In today's column we look at how you can get most out of your options trading by understanding implied volatility and its properties.

Let's go on record as saying that we are big believers in using options as trading vehicles. They are superior for just about all occasions provided you understand their properties. And though they take a little more work to understand they are worth the effort. Their ability to leverage one's capital is a major attraction. Another advantage is that by owning a put or a call you can limit your losses to the premium paid. Technically stated, option trading caters to our ability to leverage only the favorable outcomes as stated in semi-variance theory. In previous years, Modern Portfolio Theory viewed risk as the deviation from the mean. Thus any deviation, even favorable upside deviation was lumped as being negative and unwanted. Times have changed and views of how to construct portfolios are slowly changing. Eventually people will come around to understand that portfolios containing options can be shaped, formed and designed to take advantage of favorable and unfavorable risks. But we can discuss that another day.

If you want to get the most out of your options trading you need to understand all the different properties that are involved. Today we will focus on the implied volatility property and how you can use it to figure out the best option strategy given your view. The best way to do this is through an example. Let's assume that you think that a stock will rally from 80 to 120 in the next month. What trading vehicle is the best to play to take advantage of this prediction.? Is it the underlying stock itself, or an option? If it is an option which option?

This type of analysis can be done by using the calculator at our site and arranging the data in similar fashion. Nevertheless, let's take a look at some results.

The above table shows a hypothetical stock trading currently at 80 along with nine options. The options range from a strike of 70 up to and including the 110 strike. Your problem is to decide which strategy will optimize your expected scenario. To confuse the issue even more you have a limited amount of funds at your disposal. Let's say hypothetically you have only $50,000 to trade and from that you have to quantify which trading strategy is best given the scenario of the stock rising from $80 to $120 in a month's time.

The first place to start this comparison is by figuring out what kind of return purchasing the underlying stock only will provide. With $50,000 we can buy 625 shares of this stock This is arrived at by dividing our entire $50,000 by the stock's per share price of $80 thus giving us 625 shares.

If in a month's time the stock moves as expected to $120 our profit will be ((120-80)*625)=$25,000 or a return of 50%. That is pretty darn impressive. With those types of returns you will be the envy of just about any cocktail party. Nevertheless, let's see if we can do better than that by trading an option.

For the options trade, we assume that we will only allocate 5% of our $50,000 or $2500 in capital. This is done for a variety of reasons. Speaking from experience as an old trader, you realize that the key to success in this game is always having money available to play the game. Therefore, you never want to wager all your money on a single bet--no matter how confident you are of that bet. You may also want to lower your risk by simultaneously diversifying your portfolio with other option trades. For most beginners and intermediate traders the best thing to do is to under allocate your funds applied to each trade until you have established a history with your trading system. This history includes a full economic cycle--both an up and down market.

In our case, we will use only 5% or $2500 of our available capital to invest in one of the options. (The 5% level was arbitrarily picked but there are books on how to determine the optimal fractional amounts. If you want to know more on this matter I suggest reading books by Ralph Vince.) Given that we now know how much we are willing to allocate to an option we are ready to start the search for the optimal option given our risk reward appetite. In the first two rows of the table below we see the individual strikes along with the associated option costs. The third row shows the number of option contracts available given the $2500 limit we have instituted. In practice you can't trade fractional amounts of an option but for demonstration purposes we will allow it.

Therefore, our choices are now seen as buying either 1.4 calls of the 70 strike at $17.89, or 1.72 calls of the 75 strike at $14.52 and so on finally finishing with the possibility of buying 31.68 calls of the 110 strike calls at $0.79. Purchasing any of those options will cost us a total of $2500 as per our self-imposed limit.

Our next step is to evaluate each of the options after the following adjustments: one month's passage of time, the stock moves up to $120 and our estimate of the subsequent shift in the volatility's skew. The table below shows those results.

Seen in the above table are our ideas of where we expected the market to go. Our next step is to compare the two option results.

Figure 1. Our first set of option strikes and prices. Non-adjusted options.

Figure 2. Our second set of option strikes and prices. Options adjusted per our views.

Figure 3. The dollar difference between option prices. Ranked according to biggest dollar gain for individual option.

Figure 4. The percentage change between for each option. Ranked according to greatest percentage return per individual option.

Figure 5. Actual total dollar results given our $2500 investment and subsequent market moves.

From the information above we can see some interesting results. Firstly, in-the-money or at-the-money options don't always provide the best total returns. It really depends on the quantity traded, the time frame in which the move occurs along with the magnitude of the move. The bigger and the faster the move the better the out-of-the-money options will perform overall. Secondly, volatility has an impact as well. Depending on the skew it sometimes works in your favor or sometimes works against you. In this case, it worked in our favor. By us catching the move to 120, we were able to ride up the out-of-the-money skew and take advantage of the higher in-the-money volatilities. By riding the skew, I mean the out-of-the-money options initially had lower volatilities at the start of the trade but by the time the trade ended they ended they were now in-the-money options and reflected this higher volatility skewing.

Through this mixture of properties and market moves the 100 strike option was able to give us virtually the same return as our cash purchase of stock. With a mere $2500 worth of the 100 strike options we were able to produce a return of $22,981.19 for a return of approximately 919% on our money. This is pretty darn good and we didn't tie up any more capital than was needed. It is even possible that we could have done better by purchasing the 105 or 110 calls. By purchasing one of those options we could have turned in even more impressive results of $35,908 or $57,541.

In conclusion, when you have an opinion about a market it is always best to at least try and give options a chance to be the investment vehicle of choice. In analyzing your market view against an options background you may find a way that is better, cheaper or more efficient that allocating all of your resources to a single trading idea.