Options or Equities: Which is Better to Own?

As the options market has expanded it has presented an opportunity that many are not aware of or not even considered. The opportunity arises from the very question that drives ownership in shares and thus presents us with the question at hand. Options or equities: Which is better to own?

Being a former Market Maker on the CBOE, I was taught that stock was only a temporary hedge against the positions we carried and there only to negate the deltas until a position could be altered, hedged or taken off. Retail and investor portfolio management is a little different.

One consideration is time. How long does one intend to own the shares? If the answer is short-term, the risk is in the favor of owning the option. Another consideration to ponder is that of freeing up cash to better utilize capital or even having proverbial bullets in the arsenal. The use of options is often less cost intense as opposed to owning shares outright. True, stocks can be leveraged to purchase other stocks, but in a down market, a portfolio can be highly vulnerable should the investor be unable to meet a margin call or calls.

Dividends are one of the reasons that owning stock makes sense. The effort of watching an investment should be something in the nature of due diligence. Investors should know when quarterly earnings are released and when and what the dividend declared is as well as the record date (the ex-dividend date is set based on stock exchange rules, usually two business days before the record date).

The formula to consider is: risk of ownership in stock vs cost of an ITM call + extrinsic value. What is the cost of swapping stock for options and what are the reasons?

Timing is the first and foremost reason that I can think of. Certain economic events can strongly impact market sentiment at any given time. The release of minutes from the Federal Reserve’s FOMC meetings as well as certain events like the Iraq war and the unrest and upheaval we currently see in the Middle East. Terrorist acts like the one in Benghazi and Istanbul are all reasons to consider options as a possible alternative to market exposure.

Earnings calls are another tricky situation similar to the release of economic data. Stocks like Intuitive Surgical (ISRG), International Business Machines (IBM), and Apple (APPL), just to name a few, are all prime examples of stocks that are highly sensitive to earnings data. Buying in-the-money calls for as close to parity as possible can greatly reduce risk should a company miss on their numbers. When contemplating the choice, the cost in commissions can sometimes be the only true cost in the decision. Should the shares drop and the call option moves nearer to the strike, the extrinsic value tends to remain in a call option as the stock trades lower toward that strike, allowing the purchaser to recapture some of the initial cost outlay. Stock is not as forgiving.

Elections…corporate or private, national and local……environmental concerns, zoning, taxes, etc. all affect corporate profits. The use of options in creating a portfolio greatly reduces the exposure to adverse elections and potential zoning and taxation issues on municipal levels. Global events such as economic unrest in recent years in Greece, Spain, France and Germany have had huge impacts on stocks.

Having the right to capture a dividend, while reducing downside risk, and capturing a majority of potential gains should that occur is a winning formula for both novice investors just venturing into the markets. This is the same as it is for a seasoned investor seeking to reduce exposure and put capital to work that would otherwise be tied up unnecessarily. With the market at all-time highs, preservation of capital remains key. Having cash to invest if and when the market corrects, is something that should be at the forefront of every investor’s mind at this point. Forward thinking and smart investing are without question two of the essential building blocks in proper wealth management.

In a retail account, there are tax considerations which do not apply to an IRA where individuals can buy and sell without same taxes being levied. One should consult with their accountant if concerned on this note.

In the end it comes down to comfort levels and risk tolerance. As a former Market Maker on the CBOE, I was taught that stock was only a temporary hedge against the positions we carried, there only to negate the deltas until a position could be altered, hedged or taken off. As I have now come to trade with smaller more directional positions, I find the luxury of risk reduction at specific points like earnings calls and FOMC meetings too enticing to forego. In addition, the ability to exercise and capture a dividend while avoiding potential downside risk coupled with the added luxury of upside participation is a strategy that quickly rises to the top of a conservative’s risk management arsenal; a veritable dream come true.

As always when considering trading options, understanding the dynamics as well as a few important factors can help to quickly assess the feasibility of the trade. Always watch that the stock volume is significant in that a thinly traded stock may be cause for wider options spreads between the bid and ask prices. In addition always check Open Interest vs. Daily Trade Volume in each option. In performing these two simple tasks, the decision between owning options as opposed to owning shares of stocks is greatly simplified and reduced to one simple question, that of risk tolerance. Remember General Motors and Bear Sterns, two market stalwarts that proved owning call options as opposed to shares of stock outright can greatly reduce the ‘ultimate cost of carry.’

Ross Barnett Terry
Capital Wealth Planning, LLC
Covered Call Strategists
Illinois Indiana Regional BDO

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