Stocks versus Options

In a high-risk environment, should we use stocks or options?  Options might provide better risk management.  Let’s look at an example.

It’s 10th November 2012.  Apple (AAPL) is currently at $550.  We believe that the stock will rally within a month to $600. We feel that there is a 50% probability of this.  However, there is a possibility that it will move sideways (25%), fall further to around $500 (20%), or collapse to $275 (5%).

Options Example

We put on a bull call spread: buy a call option at the money ($550), and sell an option out of the money ($600).

BUY 22-Dec $550 Call @ $23.20
SELL 22-Dec $600 Call @ $6.67
Total Investment $1,653 for 1 contract (100 shares)

If the price of the stock goes up to $600 one week before expiration the spread will be worth $3,850 ($47.60 – $9.10).
If the price of the stock goes sideways the spread will be worth $862 ($9.10 – $0.48).
If the price goes to down to $500 the spread will be worth $32 ($0.48 – $0.16).
If the price goes way down to $275 the spread will be worth -$8 ($0.02 – $0.10).

OPTIONS Future Price Probability Value
Up $600 (+9%) 50% $3,850
Sideways $550 (0%) 25% $862
Down $500 (-9%) 20% $32
Way Down $275 (-50%) 5% -$8
Return $2,146.50

The probability-weighted value of the spread is $2,146.50, so the return is $493.50 or 29.9%.

 

 

Stock Example

We buy stock.

BUY 3 shares @ $550
Total investment $1,650 for 3 shares

If the price of the stock goes up to $600 the stock will be worth $1,800.
If the price of the stock foes sideways the stock will be worth $1,650.
If the price goes to down to $500 the stock will be worth $1,500.
If the price goes way down to $275 the stock will be worth $825.

STOCKS Future Price Probability Value
Up $600 (+9%) 50% $1,800
Sideways $550 (0%) 25% $1,650
Down $500 (-9%) 20% $1,500
Way Down $275 (-50%) 5% $825
Return $1,653.75

The probability-weighted value of the stock is $1,687.50, and the return is $3.75 or 0.2%.

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