The previous options thread contained some interesting disagreements about the value of distributions, option premiums, and more. But what wasn't mentioned was the key motivators (aside from hedging) for speculating in options: leverage and cost.
As an example, here's how my short-term side-bet is working. Last Tuesday I bought 25 call options with a 30 strike, expiry 9/19/14. I strongly believed that LINE's PPS at the moment of 31.13 was around the bottom of an unjustified slide and that there'd be a recovery going into the ex-div date or even just before the option expiration. I paid $3,100 for the options after commissions. That same sum would have bought me 100 units of LINE. (I'm rounding off a few odd dollars.)
Hypothetically, if I sell the LINE units at $32.13 in a week or three I make $124 (less $7 commission). That sum includes the distribution. But if I exercise the options for $30 and sell the 2500 units at $32.13, I receive $2.13 x 2500, which is $5325 (less about $25 commission). That gives me a profit of about $2200 vs. about $124 had I bought 100 units of LINE with my $3100..
So whether the reward is worth the risk is an individual decision naturally. But the appeal to me is the leverage when I have some confidence (not misplaced, I hope) that the stock will move in the right direction and that the buy-in premium of the moment seems enticingly low. Finally, I think it's fruitless to compare buying the stock vs. buying the options. Too many differences.
The PPS didn't look very strong today as I expected more from the 8-K report. So it seemed prudent to exercise for 2500 shares and sell them at 31.65. That gave me $.40 profit and I don't have to be concerned about tomorrow's ex-div drop.
I hope for you that you will realize the fallacy of your approach in less than the 10 years it took me. Imo, the worst thing that can happen to a first time option buyer is that he triples his money in a week......the hook will be so deep that it is almost impossible to remove without excruciating financial pain.....
There is only one problem with this investment / speculation: no one can predict with certainty what the price will be at expiration. It is easy to calculate the fabulous return based on $32.13 because the directional bet succeeded with leverage. What if the price remained constant at expiration? Your option will be worth only $2825, resulting in a net loss of a few hundred dollars. Taking it a little further, what if the stock falls below $30 and your entire option premium goes to the option seller.
Do not get me wrong...I understand the leverage aspect of option trading and I have had some great trades dabbling in call options. But, eventually the law of averages catches up and one realizes the folly of playing a highly lopsided game where time constraint becomes your enemy. Staying long the underlying security means one can ride the ups and downs without any forced expirations. Your example also includes the exercise of options which means full capital deployment one way or the other. If capital was not a constraint, why not buy the shares outright?
If it were that simple to time the market over such a short term, every one would be doing it! Good luck with your strategy, in any case. Wish you the best.
Nkv, I exercise the LINE options because I can typically sell almost immediately into a far more liquid market than that supplied by the options exchange. And there's no margin charge because I'm not holding those shares at the end of the trading session. Also, to get out fast via the options exchange, you usually need to sell LINE options at less than intrinsic value, so exercising the options for shares typically brings in more money.
You wrote, "If capital was not a constraint, why not buy the shares outright?" Capital is a constraint if I have to pay margin on about $78,000 vs $3,100 for the options. Further, I don't want any Linn Energy distribution and an attendant K-1 with its horrors, among which are the several federal forms and totally different Calif. forms that would have to be filled out at tax time. So, clearly, I don't want to keep any LINE shares.( I already own more than 20K of LNCO. So enough is enough.)
There is no disagreement amongst the not Progressive, therefore rational humanity.
The Black–Scholes /ˌblæk ˈʃoʊlz/ or Black–Scholes–Merton model is a mathematical model of a financial market containing certain derivative investment instruments. From the model, one can deduce the Black–Scholes formula, which gives a theoretical estimate of the price of European-style options. The formula led to a boom in options trading and legitimised scientifically the activities of the Chicago Board Options Exchange and other options markets around the world. lt is widely used, although often with adjustments and corrections, by options market participants.:751 Many empirical tests have shown that the Black–Scholes price is "fairly close" to the observed prices, although there are well-known discrepancies such as the "option smile".
Huge amounts of money and the best math minds have been applied to options pricing.
Ron^3 wonders in and claims the earth is flat. that is his opinion and a god given right if he could bring himself to even wonder about the nature of something greater than himself. Which is really the foundation of his logic problem.
I thought it was rather interesting that 80% of options expire worthless. And only 10% make you money. The other 10% lose money What is so great about this type of investing? Besides not having to pay so much for the company. Seems like mote stress then worth the while. JMO