Stocks vs. Single Options vs. Option Spreads: What’s the Difference?
Do you know the difference between trading stocks, single options, and option spreads? The risk and return parameters between the three can be drastically different and it is important to understand the differences for your investment strategy. Let’s work though an example together, comparing the three investment methods performance using a 2% increase in the hypothetical stock, ABC, which has a current stock price of $100. For this example, we’re going to ignore trading
fees and commissions.
Example 1: 10 shares of stock
A 2% increase in ABC from 100 to 102 would increase the value of 10 shares of stock from $1,000 to $1,020, a gain of $20. Remember, to hold this position in a cash account, the holder of the shares would need to buy $1,000 of ABC stock upfront.
Example 2: 1 ABC $101 single call option
Let’s assume that this call option costs $1.00 to put on and that we were at the expiration date. With the stock price gaining 2$ to get to $102, this call option would still be worth $1 ($102 stock price – $101 strike price), leaving the holder of the call to breakeven. Not much excitement here, even though the stock price did in fact go up!.
Example 3: 1 ABC $101 / $102 call spread
For this spread, we assume that we are using same call as above ($101 call that costs $1.00) and a $102 call that we can sell for $0.50, forming our $101 / $102 spread that we can put on for $0.50. At expiration, this position is worth $0.50, representing a 100% gain on our initial position. With the same move, the call spread has a significantly higher gain ($50) and a much lower entry cost.
Here’s a snapshot of the returns of the hypothetical trade:
· Example 1 (stock): 2% gain on $1,000 entry cost ($20 absolute gain)
· Example 2 (single call): breakeven = no gain or loss on $100 entry cost
· Example 3 (call spread): 100% gain on $50 entry cost ($50 absolute gain)
Real-world examples may yield different results due to market pricing, but in
general these relationships will hold when comparing the three methods of trading.
Key takeaways: Stock trading costs the most and yields smaller percentage moves; single calls or puts are more expensive than spreads and have a higher breakeven (but also have the most upside); and option spreads have the lowest cost and lowest breakeven price.
While all three methods of trading can be appropriate depending on strategy and goals, it’s important to know the general differences and similarities! At Optionality, we feature a pre-packaged menu of option spreads, offering a ‘walled-garden’ approach to the trading experience. Highlighting the entry cost, max gain, and breakeven price for every trade, before execution. Check us out on the Appstore or Google Playstore!
Alec Baum
CEO & CoFounder
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Terms: “call spread,” “Expires” “positions” “71% positive” (pie chart) “positive snippets” and “negative snippets.”
“*Pre-packaged spreads are option spreads formed by our algorithm and offered as a package.”
“A bull call spread is an options trading strategy designed to benefit from a stock’s limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains.”
“An expiration date in derivatives is the last day that derivative contracts, such as options or futures, are valid. On or before this day, investors will have already decided what to do with their expiring position.”
“Positive and Negative Snippets are a proprietary output from our partner Stocksnips that aggregated the total amount of media mentions of a certain stock and takes the percentage of those that are positive or negative, as in the example shown above referencing 71% positive”
“As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation.” · “0.50 per contract”
*Options trading involves a high degree of risk and may involve total loss of investment. Options spreads, specifically, offer the benefit of projected maximum gain and loss positions (defined above as “defined risk trades” and “defined outcomes”, but in rare situations may result in gain/loss in excess of the projected cap. Optionality has several mechanisms to greatly reduce these occurrences, but we cannot guarantee they will never happen. For more information on options, Please read Characteristics and Risks of Standardized Options before deciding to invest in options.