Trading options vs underlying

[ironchef]

Ignoring leverage, is there any reason to trade options rather than the underlying?

Let's say I'm bullish on a stock and think the price distribution in 3M will be different from normal (biased to the upside). Textbook tells us that option prices only need depend on risk neutral probability and not on my view since market makers can hedge accordingly. Should I bother buying a call?

If the option is fairly priced, there is no advantage whether you buy or sell, i.e., at expiration buyers and sellers should break even in general except for commission and slippage. So, if you play this game long enough but without any smart, you will at best break even. However, professionals are saying there is a risk premium so sellers had a slight advantage (historically, IV were usually higher than actual realized volatility).

What you are saying is you have a different view and in your case the market miss-priced the option according to your analysis. If that is true, yes, you should profit handsomely.

 

[Spicer]

Volatility plays a big part. The higher the volatility the more "premium" you are going to spend money on. If you buy an option in high volatility and then volatility comes down. There can be times with the stock moves up in price while your option moves down in price.

Assuming you can get in at low volatility. What I like to do is buy leaps (far out options). I am a short term investor. I buy a stock in hopes of having a nice profit within 18 months. A 20% return over 18 months is a standard goal of mine (yes, I buy high beta stocks).

Typically, I will risk about the same to the downside. I will let a stock drop 20% before I cut my losses.

So lets assume I buy $1000 in a stock and i am shooting for a $200 return in 18 months (20% of $1000). I am willing to take up to a $200 loss. Why not buy a leap option on the stock expiring 18 months out?

If the stock drops 20% holding the stock and the option was the same (a $200 loss). If the stock goes way up in value the option most likely went up in value by way way more causing you to make way more money than holding the stock.

If the stock stays flat this is where you loss more money than just holding the stock. If the stock stays flat over 18 months your option will be worth zero meaning you loss $200. If you just purchased the stock you would be flat no losses.

What I like to do is plan for a $1000 investment but only buy the option for $200. Then take the $800 and put it in a savings account or buy something stable like the SPY.

I over simplified here. I would not wait 18 months to get out of the option. Once the option doubled in value I most likely would have sold as if I waited the full 18 months there is a very high chance I could have had a gain in the option and then not a gain. I take profits when I get them.

 

[ajacobson]

Here is a simple volatility metric you might want as a reference. Translated volatility to expected range over time. It's not very granular as we do large steps, but you can get the idea.

 

[qxr1011]

Ignoring leverage, is there any reason to trade options rather than the underlying?

no

 

[SteveM]

Ignoring leverage, is there any reason to trade options rather than the underlying?

Yes. If you are a trader who is undisciplined when it comes to honoring your stop-losses, buying calls and puts can protect you from your own self-destructive tendencies. Worked for me.

 

[Pekelo]

Beside leverage, with options you can make TIME working for you, instead of against you. Sometimes it is hard to borrow a stock for shorting but you can sell calls or a vertical call on it anytime.

Also range plays. You are not sure about the stocks big movement but you are "certain" that it will not move more than X. Then you sell ICs and verticals...

 

[viruscore1]

Ignoring leverage, is there any reason to trade options rather than the underlying?
Let's say I'm bullish on a stock and think the price distribution in 3M will be different from normal (biased to the upside). Textbook tells us that option prices only need depend on risk neutral probability and not on my view since market makers can hedge accordingly. Should I bother buying a call?

If you are total bull. Yes you can buy call. You can also sell near the money put to pay for the call. Now you are in long position with out spending a nickle. How about that, fyi this is referred to as a synthetic long...

 

[toonerdy]

I'm not any kind of expert, but I think there may be United States income tax advantages in some cases, such as avoiding Unrelated Business Income Tax (UBIT) in some trusts, including retirement accounts.

In a taxable US account, perhaps there might be advantages for using options to avoid adjusting a position in the underlying if it makes a difference between tax rates for short and long term capital gains rates, although I suspect that wash sale and straddle rules greatly limit such opportunities.

 

[JackRab]

Here is a simple volatility metric you might want as a reference. Translated volatility to expected range over time. It's not very granular as we do large steps, but you can get the idea.

Good post.

But you use 2 different methods. You're mixing calendar days up with business days...

The formula you use is : vol(yearly) x sqrt(DTE/365)
But not for 1 day expiry, then you use: sqrt(1/260)

Your daily number are too high... A vol of 19.1 equals a 1% daily move... 19.1 x sqrt(1/365)

 

[traider]

Let me rephrase the question in another way, for those familar with options, is it wrong to use real world probabilities in option valuation assuming all the black scholes assumptions hold?