The Smart Profits Report: Issue #202
Wednesday, April 20, 2005 Stock Options: How to Buy $2,446 Worth of MSFT for $1,270
By Lee Lowell
Advisory Panelist, Mt. Vernon Research Why would anyone want to pay $2,446 for something they could get for $1,270? That's a great question, and for the life of me I still can't figure out why people are doing it every day. Since I've been in the trading business for 15 years now, I get many requests for which stock people should buy, or what I think of a stock that they recently purchased. I usually decline when asked to recommend a stock for someone, but I know I can get more bang for my buck by purchasing stock options instead of buying the stock outright. That's why I immediately go into my speech about how buying options is superior to buying a stock outright, not only because it will cost less, but there is less downside risk as well. My modus operandi has always been about how I can save money on everything I do. It's not that I'm a cheapskate, but if there is a way to buy exactly what I want for a cheaper price, then for sure I'm going to do it. That includes clipping coupons, using employee discounts, buying on eBay or Priceline, and sure enough, buying stock options instead of actual stock. Buying a Blue Chip at a 50% Discount How do we pay $1,270 for something that's worth $2,446 and end up with the same product for less risk? In the financial world that problem is solved by using stock options instead of actual stock. Take a look at this example using Microsoft (Nasdaq: MSFT)… As of the close on April 17, 2005, MSFT ended the day trading at $24.46. Anyone who wanted to buy 100 shares of MSFT would pay a total of $2,446. The total risk in this trade if MSFT ever happens to fall to ZERO will be $2,446. We know that's an unlikely scenario, but that's the total risk. Our breakeven price is $24.46. Anything above $24.46 is profit; anything below $24.46 is a loss (excluding commissions). The option chain lists all the available options for MSFT with an expiration date of January 2007, almost two years away. Looking at the "Bid" and "Ask" columns, the $12 call finished with a value of $12.70 (splitting the bid/ask). 
If you buy this option, it will cost you $1,270, almost 50% cheaper than buying MSFT shares outright. Our total downside risk in this case is $1,270, which is what it cost us to buy this option. Our breakeven price on this trade is $24.70. In order to find the breakeven price, we must add the option premium of $12.70 to the strike price of $12, which equals $24.70. (When dealing with option prices, you must multiply the premium by the $100 multiplier to get your total cost - in this case, $12.70 x $100 = $1,270). Stock Option Advantages Okay, so our breakeven price with the option is 24 cents higher than if we actually bought the shares outright. No big deal. But let's look at the advantages to buying the option. - It cost us less actual dollars to buy it - $1176 less dollars to be exact, almost 50% cheaper than buying the stock.
- Our total downside risk is only $1,270.
- And one of our biggest advantages is that we'll get to participate in the same amount of movement that MSFT has during every trading day.
How do we know we'll benefit from moves in the underlying stock? Delta, baby! The Secret of Delta - Stock/Option Price Correlations Explained Look at the column labeled "Delta." That number tells us, percentage-wise, how much the option price will move in conjunction with a move in the underlying stock. The $12 call is giving us a Delta of 100%. That means the option will move practically penny for penny with the stock. If MSFT moves up 50 cents, the $12 call should increase in value by 50 cents, as well (give or take a few pennies). It also works to the downside as well. If MSFT goes down 80 cents, the option will fall about 80 cents as well. Just in case you're wondering what the $12 call does for us… It allows you to buy MSFT for $12/share anytime until the option expires in January 2007. But in order to buy MSFT at $12/share, you must pay up the initial $1,270, which is the option's premium. As we said earlier, you breakeven price is now $24.70, and the most you have at risk is $1,270. As with any option purchase, the most you can lose is the cost of the option. Looking at the "Drawbacks" - And Finding None Are there any drawbacks to this strategy? In my opinion, not really, but I'll tell you what other people might think are drawbacks… When buying options, you do not get to receive dividends that any company may pay. Is that a reason to not buy the options? Not for me. I'll gladly settle for an investment that costs me almost 50% less in total dollars, half as many total dollars at risk, and the opportunity to participate in all the same movement. Remember, dividends don't always cushion the fall of a stock in a downtrend. The other drawback may be the limited life span of the options. I don't know about you, but if a stock I own doesn't make the move I anticipated within two years' time, I think it's time to find another stock. In terms of drawbacks, that's all I can think of. So the next time you're thinking of buying stock, make sure you check your options (literally). Good luck, Lee Lowell Today's Smart Profits Cribsheet Check out our Smart Profits Glossary for definitions of terms like "delta" or "trend" found in today's article.
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