Why It's Often Best to Sell Options and Not Buy Them
Investing using options is very different from constructing a classic long-term buy-and-hold portfolio.
In this segment from Motley Fool Live that first aired June 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss the reason Foolish investors would rather sell options than buy them.
Ellen Bowman: Moving on to number 3. We write options more often than we buy them. One of the reasons I know that we do this is because we get paid and we like to get paid. Can you elaborate? What else are we more often the seller than the buyer?
Jim Gillies: So an option writer? All that just means is seller. You and I know that, but just to reiterate. We use lingo, we get into lingo. All options writing is just that means that we sell it. The reason we are more often sellers than buyers, for the simpler strategies. For some of the more complex strategy, it often involves selling and buying together that analogy. I like to say options are like Legos.
If you are a buyer of an option, OK? Starbucks (NASDAQ:SBUX) is about what? About $111 today, and let's say Starbucks is going to do just fine post-pandemic, and I think the stock price is going to go higher. I don't know how much higher, but I think it's going to go higher. I am going to try to profit from that, so I'm going to buy a call option. Fools will hopefully remember that a call option is the right to buy between now and the expiration date of the option, and as Ellen said earlier, it's for 100 shares per contract but the right to buy between now and expiration at a pre-determined strike price. I'm just going to pull up an option chain for Starbucks here through the miracle of my computer being super slow and staring at me. That's great.
Bowman: It only does that when we're online too. It works fine when I'm not on Zoom scrambling.
Gillies: Yeah, no kidding. Okay, here we go. Now, it's finally pulling up here. Let's say we want to go out to January of 2022 just for fun. The stock is about 111.40, and I'm going to go out and I'm looking at the January options. That expire in, well this is June, so it expire in seven months. I look at that and I see the $110 strike is the closest to the current price, $110 strike. That call option, it's going to cost me around $8.90 to buy it, just shy of nine bucks.
Bowman: If you want to buy the right to purchase a stock at $111 through next January, you're going to have to pay eight dollars a share to do it.
Gillies: A hundred and ten.
Bowman: Thank you.
Gillies: A hundred and ten, yeah, that's the right price. Yeah, that's the current stock price. But you can see the problem already, right, Ellen?
Bowman: You'd have to make more than nine dollars just to get back to even.
Gillies: Exactly right. Yeah. Even though the strike price is $1.10 on this option, you don't need Starbucks over 110 to make money. You need it to be over 119 to make money.
Bowman: Just to get back, yeah.
Gillies: Yeah, just to break even. The option buyer has to work and overcome. Yeah, you pay upfront. Again, I mentioned earlier, you can be right and still lose money. Let's say you're right in Starbucks. Starbucks goes to $130 in March of 2021.
Bowman: There are real calls on it, let's say.
Gillies: We're still back at the first one. It's $110 option that expires in January. You were right. It went to 130, but it was two months after expiration of this option. So you were right. Stock went up sharply, but you lost money because those calls, the $110 calls, will probably go to zero or you'll end up selling them for less than you paid for them. That's a problem with being a buyer, and it seems a little weird recently with all these people chasing meme stocks and buying the YOLO calls and whatever.
Gillies: They're getting a good outcome for a bad process.