Stocks at a Discount: Call Options for Traders

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Based on its growth prospects, Alphabet Inc. (Nasdaq: GOOGL) appears to be an attractive stock. Amazon.com, Inc. (Nasdaq: AMZN) also appears to be attractive. The problem for many individual investors is their price with both stocks trading above $700 for much of the past year. For a small investor, one with an account of $5,000 or even less, these stocks can be out of reach. One share could represent 15% of the account or more.

High-priced stocks present small investors with a problem. There are about 60 stocks priced at more than $200 a share and some of these stocks are among the market’s best performers, capable of delivering large gains despite their large size. But, with limited investment capital it might not be possible to buy even one share of these stocks without taking too large a position.

There is no exact answer as to how much of a stock is too much to own. Jeff Bezos, CEO of Amazon.com, is believed to have more than 80% of his wealth in AMZN stock. However, different rules apply to Jeff Bezos. Even if AMZN goes to zero, Bezos would still have more than $10 billion in other assets. In his case, even a large loss in a stock making up 80% of his portfolio will not impact his lifestyle. Most of us are not in that position.

Many experts advise risking no more than 2% of your trading capital in any one stock. This is another extreme case. Risking 2% could result in owning 50 stocks which is just too many for small investors. With 50 stocks, no one stock has a large impact on performance. For an investor with a $5,000 account, a 2% position size would represent an investment of $100 in each stock. If one stock soared by 200%, the gain of $300 would not add much to the small investor’s wealth. To benefit from big wins, a more concentrated portfolio is required.

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The correct answer for how much money should be invested in each position is probably somewhere between 2% and 80% and depends on an investor’s risk tolerance. The truth is a small investor should probably have 10-20%, or maybe a little more, of their account in each position. With an effective risk management strategy, large gains in investments of this size will have a significant impact on wealth.

Now, back to the problem of the $700 stock. Owning one share in a $5,000 account will result in a relatively small gain in dollar terms even if the stock delivers a big gain. A 40% gain, for example, would be a gain of $280. At this rate, it could take many, many years to grow a small account into a significant amount of wealth.

Fortunately, call options can be used to address this challenge.

A call option gives the buyer the right, but not the obligation, to buy 100 shares of a stock or ETF at a predetermined price for a specified amount of time. For some high-priced stocks, including GOOGL and AMZN, mini-options contracts are available that cover just 10 shares. These contracts can be a valuable tool for small investors. If an investor benefits from 10 shares of a stock that gains $280 per share, the dollar gain amounts to $2,800, a return that is meaningful to almost any investor.

Before getting into a specific example, let’s address the risk of buying call options. Just like with a stock, the maximum loss is the amount you pay when entering the trade. If an option cost $5 and covers 10 shares, the risk is equal to $50 ($5 * 10 shares). Option buyers can never lose more than they invest.

Let’s run through a specific example using GOOGL assuming the stock is trading at $805. There will be options available with different amounts of time to expiration. You could buy an option expiring in less than a week and options expiring in eighteen months. There are several choices between those extremes. In general terms, the longer the time to expiration the more expensive the call option will be. This is because there is a greater chance the option will gain value with more time to expiration.

There will also be options with different exercise prices. The exercise price is also called the strike price. This is the specific price you can exercise the option for. A call option with an exercise price of $800 will be profitable if the stock is above $800 at expiration. If the stock is trading below $800 at expiration, the call option expires worthless and you would lose the amount you paid for the option at that point. You could also close the trade before expiration to limit the loss or to take a profit. At expiration, the option will be worth the difference between the market price and the exercise price. If the stock is at $820, in this example the call option would be worth $20.

An option on GOOGL expiring in one month with a strike price of $800 costs about $10. If GOOGL rises to $820 a share, this option would be worth $20 and the return on investment would be 100%. A mini-options contract would cost $100 ($10 * 10 shares) to buy and would be worth $200 ($20 * 10 shares) at expiration.

An option expiring in four months with a strike price of $800 would cost about $40. This option delivers a profit if GOOGL is above $840 in four months, a gain of about 4.7% in the stock. If GOOGL gains 5% and trades at $845, the option would deliver a gain of 12.5%, more than the twice the gain an investor in the stock realizes. This demonstrates the leverage options provide. In general, a profitable option trade will deliver a larger percentage gain than an owner of the stock would receive.

For small investors, options might be the best choice for trading high-priced stocks. At $40 a share, an investor would spend $400 for a mini-option covering 10 shares of GOOGL. This represents 8% of a $5,000 account. Ten shares of GOOGL would cost $8,000, more than the small investor has in their account. Without options, there would be no possibility of participating in the potential gains of 10 shares of the stock.

There are also options on low-priced stocks. A call option on a stock trading at $50 might cost just $2. This would allow an investor to increase the potential gains in their account. Instead of buying 20 shares of stock for $1,000, they could buy 5 call options equivalent to 500 shares of stock. If the stock moves in line with their expectations, their gains could be 25 times larger with options.

Alternatively, the investor could buy call options in four or five different stocks, or possibly even more. This is another potential benefit of call options which allow small investors to diversify their accounts.

There are risks, as we mentioned. You could lose 100% of the amount paid for the option. With risk management and good stock selection, losses can often be held to smaller levels. One way to avoid risk is to avoid holding options in stocks on the day their earnings report is released. While each investor must weigh potential risks and rewards of all investments, many small investors may find options provide benefits of diversification and leverage that can help them meet their goals. Options may also allow them to meet their goals years ahead of what’s possible solely by owning shares of stock.

There are other option strategies. Put options can benefit from price declines or options can be used to generate income. These strategies will be covered in other articles.