The Options University Media Room

The Options Craze: Why You Should Be Paying Attention

Veteran Floor Trader Discusses the Advantages of the Investments Market's Biggest Secret

By Ron Ianieri

Options have been around long enough to beg the question, "Why are they getting so much buzz now?" Mad Money's Jim Cramer recently exclaimed that options are the hottest, fastest growing segment of the market. Barrons shed light on baby boomers moving to options as a way to gain additional income and aid their sagging retirement portfolios. A major online brokerage firm polled its clients about which investment topics they would like to learn about. Options was the number one answer drawing in a whopping 62% of the responses. After 30 years of existence, options are now getting the attention they deserve.

Those of us who understand options have long wondered why more people do not use them. Several reasons come to mind. Due to their sophisticated nature, many investors have avoided options because of their perceived stigma of being too difficult to understand. Investors have bad initial experiences because inadequate training on their use. Finally, monikers such as 'risky' or 'dangerous' are synonymous with options thanks to the media and market leaders. Investors must take into consideration that these leaders might be in the limelight, but they are not necessary 'in the know' as it pertains to options. Options have significant value to the individual investor. They provide increased cost efficiency, are less risky, give higher percentage returns and offer more strategic alternatives.

Cost Efficiency
Options have great leveraging power. An investor can obtain an option position that will mimic a stock position almost identically but at huge cost savings. For instance, in order to purchase 200 shares of an $80 stock, an investor must pay out $16,000. If the investor purchases two $20 calls, the total outlay is only $4,000. The investor then has an additional $12,000 to use at his or her discretion. Obviously, it is not quite that simple. The investor has to pick the proper call to purchase in order to mimic the stock position properly. Still, this stock replacement strategy is viable and extremely cost efficient.

Less Risk
With less money invested, there is less risk involved. This makes options less risky than stocks. Options are also less risky because they are impervious to the potential catastrophic effects of gap openings.

Higher Percentage Returns
Options are the most dependable form of hedge and are safer than stocks in many instances. When an investor purchases stock, they frequently place a stop loss order to protect the position. The stop order "stops" losses below a prefixed price as determined by the investor. The problem is the essence of the order itself. A stop order occurs when the stock trades at or below the limit as indicated in the order.

Let's say you own a stock at $50 and you do not wish to lose anything more than 10% of your investment. You will place a $45 stop order. This order will become a market order to sell once the stock trades at or below $45. This order works during the day, but may have problems at night. You go to bed with the stock having closed at $51. The next morning, when you wake up and turn on CNBC, you hear that there is breaking news on your stock. It seems that the CEO of the company has been lying about the earnings reports for quite some time. There are rumors of embezzlement. They expect the stock to open down around $20 making $20 the first trade below your stop order's $45 limit price. When the stock opens, you sell at $20 locking in a considerable loss. The stop loss order was not there for you when you needed it most.

If you purchased a put option for protection, you would not have suffered this catastrophic loss. Unlike stop-loss orders, options do not shut down when the market closes. They give you insurance 24 hours a day, seven days a week. This is something that stop orders cannot do. This is why many consider options the one and only perfect form of hedge.

Furthermore, as an alternative to purchasing the stock, you could have employed the stock replacement strategy where you purchase an in-the-money call instead of purchasing the stock. There are options that will mimic up to 85 percent of a stock's performance, but cost one-quarter the price. If you purchased the $45 strike call instead of the stock, your loss would be limited to what you spent on the option. If you paid $6 for the option, you would have lost only that $6. Not the $31 you would have lost if you owned the stock.

You do not need a calculator to know that if you spend much less money and make almost the same profit that you have a higher percentage return. Options normally offer investors a much higher percentage return. For example, using the scenario from above, let us compare the percentage returns of the stock (purchased for $50) and the option (purchased at $6). Let's also say that the option has a delta of 80, meaning that the option's price will change 80% of the stock's price change. If the stock were to go up $5, your stock position would provide a 10% return. Your option position would gain 80% of the stock movement (due to its 80 deltas) or $4. A $4 gain on a $6 investment works out to be a 67% return - far superior to the 10% return on the stock.

More Strategic Alternatives
The final major advantage of options is that of increased investment alternatives. Options are an incredibly flexible tool. There are many ways to use options to recreate other positions. We call these positions synthetics. Synthetic positions give multiple ways of attaining the same investment goals. This can be very useful. While synthetic positions are an advanced option topic, there are many other examples of how options offer strategic alternatives.

Many investors use a broker that charges a margin when they want to short a stock. This margin requirement is sometimes cost prohibitive when shorting stock. Some investors are involved with brokers that do not allow for the shorting of stocks by rule. No brokers have any rules against investors purchasing puts to play the downside. The inability to play the downside when needed virtually handcuffs investors and forces them into a one-dimensional world while the market trades in 3D.

The use of options also allows the investor to trade in a third dimension of non-direction that the market has. Options allow the investor to trade both the passage of time and movements in volatility - not just stock movements. Most stocks do not have large moves most of the time. Only a few stocks actually move significantly and then not too often. An investor's ability to take advantage of stagnation could turn out to be the deciding factor in whether or not your financial goals are attainable. Only options offer the strategic alternatives necessary to profit in every type of market.

Thanks to online brokerages coupled with insanely low commission costs, investors have the ability to use the most powerful tool in the investment industry just like the professionals. Take the initiative and dedicate some time to learning how to use options properly. It is the dawn of a new era for individual investors. Don't be a dinosaur!

Ron Ianieri enjoyed fourteen years of success as a floor trader on the Philadelphia Stock Exchange, including 4 years as the lead market maker in DELL computer options - one of the busiest books in history. He is currently Chief Options Strategist and Co-Founder of The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information about The Options University or options trading please visit www.optionsuniversity.com or call 866-561-8227.