Investing in stocks usually requires you to pay the stock price multiplied by the number of stocks purchased. If you want 100 shares of Google (GOOG), which is now Alphabet Inc., as of April 2020, its price is approximately US$132,100 (100 * US$1321.00).However, there is an alternative method that requires less capital: options. This is done by using call options that simulate stock movements. The deeper the funding of the call option-meaning the closer the delta is to 1-the better the ability of the option price to track stock movements.
Google Option Chain
For illustration purposes, please review the Google Option Chain obtained from Nasdaq as of September 3, 2014. The option is an American call option.
An example of an option
If you have a short-term investment horizon, you may choose a call option that expires on October 18, 2014, as shown in the table above. The strike price is the price at which you have the right but not the obligation to buy the stock. The price you pay for this option is the premium or final price. As the exercise price drops, the call option’s funds are deeper and the premium will increase. Trading volume, that is, the number of option contracts traded, will affect the bid-ask spread. The larger the transaction volume, the lower the bid-ask spread; the lower the bid-ask spread, the more investors can save transaction costs.
Suppose you buy a 520 strike price Google option at an asking price of $61.20, and the breakeven price (BEP) becomes $581.20. On September 3, 2014, the stock was traded for approximately US$575. If the stock stays at $575 before October 18th, the option price should be reduced to $55, because the strike price ($520) plus the premium ($55) will equal the stock price ($575), eliminating any arbitrage opportunities .
Since the delta of an option is 1, any change in the stock price should move the option price by the same amount. For example, if the stock price rises to $600 at maturity, the option price will become $80 ($600-520), and the return will be $18.80, which is $6.20 less than the $25 return on the stock. 6.20 USD represents the time value of the option, which will eventually decay to zero when it expires.
Opportunity and protection
Another benefit of using options to invest in Google or any other company is that options can provide protection if the stock falls sharply. In fact, you don’t own the stock, you only have the option to buy the stock at a certain price, protecting you when the stock plummets. This is because you will only lose the premium paid for the option, not the actual value of the stock.
Suppose you held 100 shares of Google stock in 2014, and the stock price fell sharply from US$575 to US$100. This means a loss of 47,500 USD. However, if you have a call option on 100 shares of Google stock, you will only lose the premium you have paid. If you buy call options on 100 shares of Google stock at a price of $61.20 per share, you will only lose $6,120 instead of $47,500.
Compared with short-term options, long-term options have relatively poor liquidity, so transaction costs in the form of bid-ask spreads will be higher. figure 2 It shows that the number of trades of call options expiring in June 2016 is less than that of expiring in March 2015, which is less than expiring in October 2014. Therefore, long-term use of options to invest in stocks can become very expensive and difficult. An alternative method is to extend the option at each expiration, but this also increases transaction costs in the form of higher brokerage fees.
For some companies and other securities, there are also mini-options with 10 shares instead of 100 shares. This is useful for smaller investors and hedging odd shares (that is, not multiples of 100) of specific stocks. Unfortunately, the trading volume of these options is not high, and mini options are not as common as regular options.
Using options is a cost-effective way to gain exposure to stocks without risking large amounts of capital, while still being protected from declines. One of the main disadvantages is the liquidity of the option contract itself. If you are an investor who is interested in investing in a company with a high share price (ie Amazon (AMZN), Tesla (TSLA) or Google) without taking up too much capital, options may be the right answer for you.