Pros and Cons for using options as a direct substitute for the underlying?

OddTrader · Jul 30, 2009

1. What are the Pros and Cons for using options as a direct substitute for the underlying, Theoretically?

2. Do you think the theoretical Pros and Cons that you know are really useful, Practically?

3. What are the trade-offs in general, when using options instead of the underliers?

4. Most importantly, have you improved your trading performance after the substituting process (or just giving-up)? Profitability %, or Smoother curve, or both?

Thanks!

wayneL · Jul 30, 2009

Quote from OddTrader:

1. What are the Pros and Cons for using options as a direct substitute for the underlying, Theoretically?

2. Do you think the theoretical Pros and Cons that you know are really useful, Practically?

3. What are the trade-offs in general, when using options instead of the underliers?

4. Most importantly, have you improved your trading performance after the substituting process (or just giving-up)? Profitability %, or Smoother curve, or both?

Thanks!

There is probably a book's worth in answering those.

Pro for me is that they are NOT a direct replacement.

SteveGoTex · Jul 30, 2009

Quote from OddTrader:

1. What are the Pros and Cons for using options as a direct substitute for the underlying, Theoretically?

Pro: You can get more Delta for less money.

Con: You are subject to the rigors of a supply and demand market for the options. This means that the options can make or lose money just because of their own trading, namely Implied Volatility.

2. Do you think the theoretical Pros and Cons that you know are really useful, Practically?

Yes, I do. For example, if I hold the opinion that the price SPY or QQQQ will be substantially higher by the end of 2010, I could purchase LEAPS at the money, and just hold those. I could also take the cash I would have used to buy those ETFs and place them into a risk free investment, like a CD, savings account or similar. If that opinion holds true, I will realize lower but substantial gains than a pure investment in the ETF. If I am wrong, then I only lose a relativily small amount.

In this example, I am not trading, I am investing.

3. What are the trade-offs in general, when using options instead of the underliers?

In my example, you are trading a smaller gain for protection, the classic hedge.

4. Most importantly, have you improved your trading performance after the substituting process (or just giving-up)? Profitability %, or Smoother curve, or both?

I sleep better.

HTH
Steve G

heiasafari · Jul 30, 2009

You question is ambiguous I think...

Do you mean using options as a replacement for a stock? ex: I buy calls on SPY if i think its going to go up.

Or

Do you mean using options to create a synthetic position that would be equivalent to having bought SPY.

Those 2 things are very different, they do not have the same risk, not the same reward and basically nothing else is the same.

In a nutshell:

One of the main advantage of the first strategy is of course leverage, you need less money to be exposed to the underlying. Big draw-down: time decay, in the end you will make a loss even if the stock as laid still...

The second strategy converts any interest or dividend into capital gains, which is a big advantage tax-wise. A big disadvantage is more commissions = higher buying price than just buying the underlying.

spindr0 · Jul 30, 2009

Long options:

Limited cost/loss
Lower margin
Leverage
Lower delta so less bang for the buck per underlying $ move
Change in implied volatility (may help or hinder)
Time decay erodes your position
Timing: they expire

xflat2186 · Jul 30, 2009

Quote from heiasafari:

You question is ambiguous I think...

Do you mean using options as a replacement for a stock? ex: I buy calls on SPY if i think its going to go up.

Or

Do you mean using options to create a synthetic position that would be equivalent to having bought SPY.

Those 2 things are very different, they do not have the same risk, not the same reward and basically nothing else is the same.

In a nutshell:

One of the main advantage of the first strategy is of course leverage, you need less money to be exposed to the underlying. Big draw-down: time decay, in the end you will make a loss even if the stock as laid still...

The second strategy converts any interest or dividend into capital gains, which is a big advantage tax-wise. A big disadvantage is more commissions = higher buying price than just buying the underlying.

Great answer the only thing I would add is slippage in the options and having to cross two markets for the pure synthetic

dagnyt · Jul 30, 2009

Quote from heiasafari:

The second strategy ...A big disadvantage is more commissions = higher buying price than just buying the underlying.

Don't forget PIN RISK

Mark

Tom1am · Jul 30, 2009

I have read about in the money leaps being used as surrogate have read it is a close substitute if the premium is all intrinsic value.

Here is the article I am referring to. I am doing this with EEM in a virtual account and have had some good success

http://www.investopedia.com/articles/optioninvestor/04/021104.asp

dcvtss · Jul 30, 2009

Quote from SteveGoTex:

Yes, I do. For example, if I hold the opinion that the price SPY or QQQQ will be substantially higher by the end of 2010, I could purchase LEAPS at the money, and just hold those. I could also take the cash I would have used to buy those ETFs and place them into a risk free investment, like a CD, savings account or similar. If that opinion holds true, I will realize lower but substantial gains than a pure investment in the ETF. If I am wrong, then I only lose a relativily small amount.

Isn't there an interest rate built into the LEAPS and won't interest rate moves affect them? You know the whole no free lunch thing...

xflat2186 · Jul 30, 2009

A deep ITM leap is not always easy find. Donât forget the further out in time you go the closer to .50 deltas all the options get. You'd need a really really deep ITM option to get close to 1.00 deltas and then you'd incur a huge bid/offer spread and if the underlying moved you'd also be subjected to huge Vega risk. Thats in addition to the Rho risk mentioned above.