When I talk to people about options, I often get, “Options are Dangerous” and indeed they are. I will not argue that. My argument here is that Stocks are ‘more’ dangerous.
People also think guns are dangerous as the news only talks about the bad things that happens with guns. You don’t here the stories of homeowners and shop owners detaining a burglar at gunpoint, nor do you here of the countless times a police officer stops a wanted felon by simply taking them into custody ‘at gun point’. These are common occurrences using guns where there is a ‘win’.
Options are the same. The media has made them ‘dangerous’ by years of propaganda, coupled with people who “traded em’ in the 80’s” and didn’t do very well. That has all changed with the way options are traded today.
I want to make a comparative of 100 Shares of the S&P 500 versus a simple options spread. In the comparison, I chose a Short Vertical Call Spread, as that would probably be a good trade to put on right now, as we are very ‘toppy’ in the markets and have a small down move.
To compare, if you were to buy the S&P 500 index, or SPY, it would cost $178.11 per share (on 12/14/13, Saturday) and 100 shares would cost $17,811.00.
The average “Stock Market” gain over the live of the markets from 1925-2012 is roughly 6.9%, more recently only 5.45%. For purposes of this study, we will round up to 5%. You can read the reference material at this post:
So to make 5% on your 17,811, you would have to risk $17,800 for one year. This would yield $1,246.77 profit if all goes well. For purposes of this example, we won’t consider dividends, but that would be a ‘negligible’ offset to this example.
Now, looking at the trade on the graphic, we would do a short call vertical and close it when we made 5%. This is a one month option, so our 7% would be made in one month. The cost of a $2 wide vertical and selling it at roughly 1/3 the width, in this case $.62, would cost $140.50 in margin. To make 5%, we would have to buy back that option at $.58. So to confirm the math, 140.50*.07=.08
Now this is the interesting part of the options trade versus a S&P 500 trade. Your options trade would be completed in approximately 30 days, so you could put a similar trade on again in the next month. Give you did this, here are the ‘stats’ on this options trade:
- $140.50 in risk every month for 12 months at 5% Return on Investment (ROI) yields: $96.00 in profit
- Your Yield on your investment annually is: 68.3%
- Your risk at any given time is $140.50 of your hard earned Cash.
- Using the “Rule of 72” you would double your money every 1.059 Years!
- A 3% decline in the S&P 500 for the year you did this (If it were to go down the year you did this): $0 Dollars (Using the Trade we chose)
Now, comparing that to the S&P 500 Stock trade (SPY), you could find the following:
- $17,800 in risk every month for 12 months at 5% Return on Investment (ROI) Yields: $1246.77
- Your Yield on your investment annually is: 5%
- Your risk at any given time is $17,800 of your hard earned cash
- Using the “Rule of 72” you would double your money every 14.40 Years
- A 3% decline in the S&P 500 for the year you did this (If it were to go down the year you did this): $534.00
Now, the S&P can go down and up in a year and that really isn’t factored into this equation, however, you need to consider the strong evidence above. If you were to commit the same $17,800 to options trades and made the money explained above, you would make $12,104.00 on your $17,800 investment! Even if you lost occassionally on a small trade, wouldn’t you almost certainly do better than the $1246.77 the long S&P trade yields? Wouldn’t you also lower your risk on every win?
There a couple of points I wanted to drive home with this comparison:
- Options are less risky than long stocks
- You can start trading options for as little as $140.50
- Markets go up and down, so with stock investing you can easily end up ‘down’ on the year!
If you have questions about the math; the options trade we described; or anything about this story, please post a comment below and we’ll answer it!
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