How to decide whether to buy a stock or a call option - Motilal Oswal
How to decide whether to buy a stock or a call option - Motilal Oswal

How to decide whether to buy a stock or a call option?

Content will come hereLet us say you are bullish on a stock. You have 3 options; you can buy the stock, you can buy the future of the stock or you can buy the call option. In case of buying in cash, you pay the entire amount upfront and hold on to the position. In the case of the future position, you can take a leveraged position by paying a margin. On the date of expiry, you either close the position or roll it over to next month. Lastly, there is the option, where you can get a right without an obligation. That means your loss will be limited to the premium paid; nothing more. However, your profits are unlimited on the upside.

 

So, which is more profitable; futures or options. Let us look at stocks vs futures vs options and let us figure out the options vs futures advantages. That brings us back to the fundamental question. When should buy the stock and when should you buy the call option instead? Here are 5 criteria that you can use for this decision process.

 

1.  Are you playing price or time?

This is an interesting question and you need to understand this concept well. When you buy SBI and expect the stock to go up from 280 to 350 in 8 month time, you can buy the stock because 25% appreciation in 8 months is very attractive returns. But the problem in this case is that you only get the benefit of stock value movement. What if you want to play on price movements and on expectations? The expectations based movement exists only in call options and put options and this is called the time value of money. Let us see how they compare.

 

In the first instance, say you bought 3000 shares of SBI at Rs.280. At the end of 8 months you sold out your 3000 shares at Rs.350 and booked a profit of Rs.2,10,000 on the position. Now how do we play this story through options? You buy 1 lot (equal to 3000 shares). Say the Rs.290 call option at Rs.10. Here when the strike price of Rs.290 is above the market prices, you still pay Rs.10. The entire value is time value. When the stock price goes up to Rs.310, let us assume that the price of the 290 call goes up to Rs.33. Now if you book the position, you make a profit of Rs.69,000. Effectively, you have played time value very smartly. Instead of waiting for 8 months to earn Rs.2,10,000, you have earned 1/3rd the profits in the first one month itself. Time value has worked in your favour.

 

2.  Are you playing direction or volatility?
If you are clear about the direction of the stock over the medium to long term, you can as well buy in the cash market and sit tight on it. When the target price is reached, you book profits and walk out. But what if you are bullish but also expect the stock to be very volatile in the next 2-3 months. Then you should go for a call option. Volatility is always beneficial to the buyer of the call option and works against the option seller. So, if you are playing for volatility then preferably play it through call options.
 
3.  Are you playing key events?

You don’t want to commit your funds ahead of key events like a big order bid, quarterly results, outcome of FDA investigation etc. Buying in the equity market is too risky. Rather you can play the even with a call option. In fact, if you are sceptical about the direction of the impact, you can also play through straddles and strangles. Message is that events and big announcements can be played better with the help of options rather than through the cash market positions.

 

4.  Are options underpriced or overpriced?

Figuring that out is not too complicated. Typically, when there is too much optimism in the market, call options tend to be overpriced. Similarly, when there is too much of pessimism in the stock markets, you will find most call options cheap. You can use the Black and Scholes equation to determine whether the particular option is underpriced or not. Ideally, buy options that are underpriced as they are a safer bet for you. Remember, when you buy call options you are paying for price, expectations and for time. You need to cover all that to make a profit. Therefore, only focus on buying underpriced options.

 

5.  Are you seeking investment or protection
What is the difference between buying a stock and buying a call option? The difference is all about downside risk. When you buy a stock, your downside risk is unlimited. Theoretically, share prices never go to zero, but we have seen in cases like Kingfisher and PC Jewellers that value destruction can be rapid and brutal in equities. When you buy options, your maximum loss will be limited to your premium paid. That is the protection you have. So if you are looking at protection against volatility, options are a better choice for you!
 

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