Why would anyone buy a stock option?
Jun 23, 2010
Why Would Anyone Buy a Stock Option

When buying a put or call option, the trader's usual objective is to earn a profit.

That may seem obvious, but investors also buy options to hedge, or reduce the risk of owning, other positions. For example, the owner of a large stock portfolio may buy put options as as insurance against a market decline.  The idea is the the puts will profit on that decline, offsetting a portion of the loss that comes from owning stock. Thus the puts are NOT bought with the intention of earning a profit.  They are used as insurance. 

For now, let's simply concentrate on the basic reason most traders buy options: to make money.

Ina previous post I explained how difficult it is to earn a profit when buying options:
  • You must correctly pick direction
  • The timing must be accurate, or the option can become worthless
  • The size of the move must be estimated to ensure buying the correct option
Nevertheless, buying options is a favorite strategy, especially among beginners.  One reason is that the payoff can be substantial.  It's also true that the chances of success are much better than buying a lottery ticket.

Here's an example of an INEXPERIENCED hypothetical call buyer's thought process:
"I've been watching my favorite stock, BVO, and it has declined to a point where I believe it's a good buy based on value.  The current price is $44 and according to my system, this stock can move to $50 or perhaps $51 withing the next 2 months. I don't have $4,400 to buy 100 shares, and don't believe there's enough profit potential if I buy 10 shares.

However, BVO Aug 50 calls are only $0.50 each.  That's $50 per contract.  I can buy 10 of them for $500, plus commissions.  If the stock runs past $50 quickly, I should be able to earn a nice profit."

This inexperienced trader goes ahead and buys 10 BVO Aug 50 calls.  It's true that if the stock turns and moves higher and does it when there is still plenty of time (3+ weeks) remaining in the life of the option, then a good profit can be had.  And of the stock roars towards $55, a very large profit will be available.

The problem is that this is the wrong call option to buy.  If the stock moves higher, but at a slow pace, it's very possible for the stock to approach 50 as the clock runs out and August expiration day arrives.  To make money, the stock MUST move quickly or it must move near $51 ($50.50 is break even at expiration, but there are commissions to pay).

It would be much better to buy  one Aug 40 call or perhaps two Aug 45 calls in the scenario.

 It's not easy for the beginner to understand which options to buy.

Mark D Wolfinger

Expiring Monthly: The Option Traders Journal