The Decision: Buy The Shares Or The Option
Kirk Du Plessis | Jul 26, 2012 12:15PM ET
Let's start with a question. If you’re going to buy a house from, would you rather buy it outright OR have a contract to buy the house at some predefined price in the future?
Naturally you might think that the next questions you'd ask are, “What’s the value of the house now?” and “What do you think the value will be in the future?”
If the value of the house now is $100,000 and you can only buy it in the next year for $105,000, then maybe it’s not a good decision. Or maybe it is a good decision - who knows! Maybe you think the value of the house is going to go up more than that in the next year and you’ll be purchasing it for below market value?
Making The Decision A Little Easier
That type of question really gets to the heart of trading and investing when we talk about buying underlying shares or buying options on those shares. There’s a lot that goes into the decision that you have to make as an investor but these topics will help make it easier.
First, well look at technical analysis. As always, technical analysis will give us some leading indicators that will help make the decision easier.
If we use things like MACD, Stochastic and Bollinger Bands we can get a good idea of where we think the underlying stock may or may not go in the future. And what’s great about all of these indicators is that you can get a pretty good estimate of how long it may take for the stock to reach a certain price range.
Time Is. . .Well, Money
The decision from there is going to be based upon one thing, and one thing only, and that's how long is it going to take that move to happen? For options, time is a wasting asset.
If, for example, you believe that a stock will bounce by 200% in, say, the next two years, then you might actually go for buying the underlying shares. If you think the stock could move in any direction after earnings though in which direction you're just not sure, then you may opt for buying the option on the stock instead of the underlying shares.
Get The News You Want
Stocks Offer Unlimited Time To Profit
Before you make a final decision you have to understand the benefits of each choice. With stock purchases, you have the benefit of time on your side. There’s no wasting asset. The value of the stock is what it is every day and you can hold it as long as you want.
While you get to enjoy the dividends, you also bare the risk that the company may go under and lose value dramatically overnight. As always, the additional benefit comes with another form of risk.
Options Offer Massive Potential But Are Time Sensitive
With options, the benefit is that you keep all the upside potential without the downside risk. That's particularly true with a call option, where you keep all the upside potential, yet limit your downside investment to just the premium itself.
If a stock goes bust, you don’t lose all your money. Instead you only lose the premium invested. The downside to options is that they are time- and price-specific. So not only do you have to be right in the direction you’re guessing the market take, but you have to be fairly certain of the timing and magnitude of the move.
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