Why are Call Options a bad idea?

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nasrullah
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Why are Call Options a bad idea?

Post by nasrullah »

I was in a conversation with a buddy yesterday who's long call options (+ margin leverage) on a few stocks he's tracking. I get why the margin leverage and I understand that risk/reward (or likely in his case just the gambling fix). What I walked away with wondering is why not purchase call options? If you want to purchase a stock and the company doesn't pay dividends, what's the disadvantage of purchasing long calls vs just the stock?

There's the cost to purchase the options and the cost for the position so the downside seems fixed and limited. But any significant movement upwards is multiplied using options right? I feel like I'm missing something major here.
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Ryzen
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Re: Why are Call Options a bad idea?

Post by Ryzen »

You have to be correct in the direction, strike, and timing. If any of those move against you, the value could go to $0 in a hurry. Owning shares, a 10% drop means you have 10% less. Owning call options, a 10% drop will most likely mean you are left with nothing.

Edit: you also have to be correct volatility. An increase in price but decrease in volatility (the IV- loosely based on what the VIX is currently at) could lead to a wash. That's called "IV Crush" and is common after earnings, when share price might soar but option values drop even when the underlying is moving in the direction you are betting it to.

I have had a lot of fun trading some small options. It's fun to make 100% in less than 24 hours, not as much fun losing your position. I've broken even on options trading and decided to retire from it for now. Too many people piling into options is making everything very volatile and hard to trade, and it's better to focus on my day job than 5-minute candle charts.
Last edited by Ryzen on Tue Sep 15, 2020 10:09 am, edited 1 time in total.
livesoft
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Re: Why are Call Options a bad idea?

Post by livesoft »

Updated: I wrote below about selling calls options and you want to buy them. I suppose I could edit and switch every "sell" to "buy" and it would still read the same way.

You may not believe this, but people do not buy call options with the idea that they are going to lose money on that. Yes, I know that you are not buying call options, but are selling them. You just need to know that people are not buying the call options that you are selling because they expect to lose money on them. And you will not be selling call options that will always make you money. That said, the last 4 call options that I sold made me money in the sense that they expired worthless to the buyer.

So what happens is that people make money selling call options until they don't. And when they don't the asset that gets called away makes even more money. It also warps your mind. If you sell a call option "Because I don't mind if the stock gets called away", then your money is stuck holding the stock you should have sold and used the money to invest elsewhere.

I realize that no one will change your mind, so I see no problem with you selling call options having some fun with them.
Last edited by livesoft on Tue Sep 15, 2020 10:08 am, edited 1 time in total.
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Ryzen
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Re: Why are Call Options a bad idea?

Post by Ryzen »

livesoft wrote: Tue Sep 15, 2020 10:01 am You may not believe this, but people do not buy call options with the idea that they are going to lose money on that. Yes, I know that you are not buying call options, but are selling them. You just need to know that people are not buying the call options that you are selling because they expect to lose money on them. And you will not be selling call options that will always make you money. That said, the last 4 call options that I sold made me money in the sense that they expired worthless to the buyer.

So what happens is that people make money selling call options until they don't. And when they don't the asset that gets called away makes even more money. It also warps your mind. If you sell a call option "Because I don't mind if the stock gets called away", then your money is stuck holding the stock you should have sold and used the money to invest elsewhere.

I realize that no one will change your mind, so I see no problem with you selling call options having some fun with them.
OP said "why not purchase long call options" so he would be buying, not selling.

OP: If you want to sell calls, you want the "theta" to work in your advantage - you want the stock to be flat so the time decay lowers the value enough so you don't get assigned. I wouldn't recommend doing this as it doesn't seem like you have a very solid understanding of how these derivatives work.
Last edited by Ryzen on Tue Sep 15, 2020 10:06 am, edited 1 time in total.
runninginvestor
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Re: Why are Call Options a bad idea?

Post by runninginvestor »

nasrullah wrote: Tue Sep 15, 2020 9:47 am I was in a conversation with a buddy yesterday who's long call options (+ margin leverage) on a few stocks he's tracking. I get why the margin leverage and I understand that risk/reward (or likely in his case just the gambling fix). What I walked away with wondering is why not purchase call options? If you want to purchase a stock and the company doesn't pay dividends, what's the disadvantage of purchasing long calls vs just the stock?

There's the cost to purchase the options and the cost for the position so the downside seems fixed and limited. But any significant movement upwards is multiplied using options right? I feel like I'm missing something major here.
Additionally, and alignment with the other post about volatility, implied volatility IV is high right now, so you're paying a premium to buy that call option. Typically with high IV environments, it's a seller's market in the options world.

Not to get too much into options, typically if you wanted to purchase a stock you want to buy low and sell high right? If you buy a call option you pay a premium to potentially buy higher.
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nasrullah
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Re: Why are Call Options a bad idea?

Post by nasrullah »

Ryzen wrote: Tue Sep 15, 2020 9:54 am You have to be correct in the direction, strike, and timing. If any of those move against you, the value could go to $0 in a hurry. Owning shares, a 10% drop means you have 10% less. Owning call options, a 10% drop will most likely mean you are left with nothing.
That's kinda what I was figuring. Either it plays out and you "make" money or you lose your bet.
Ryzen wrote: Tue Sep 15, 2020 9:54 am Edit: you also have to be correct volatility. An increase in price but decrease in volatility (VIX) could lead to a wash. That's called "IV Crush" and is common after earnings, when share price might soar but option values drop even when the underlying is moving in the direction you are betting it to.
Umm, that's terrifying.
Ryzen wrote: Tue Sep 15, 2020 9:54 am I have had a lot of fun trading some small options. It's fun to make 100% in less than 24 hours, not as much fun losing your position. I've broken even on options trading and decided to retire from it for now. Too many people piling into options is making everything very volatile and hard to trade, and it's better to focus on my day job than 5-minute candle charts.
One of my key points of my IPS is not to invest in things I don't understand. Just reading this I don't think I have any appetite to learn how options really work. One day job is enough for me.
Last edited by nasrullah on Tue Sep 15, 2020 10:08 am, edited 1 time in total.
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Impatience
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Re: Why are Call Options a bad idea?

Post by Impatience »

Generally for the same reasons that buying individual stocks is a bad idea. You’re trying to outsmart the market. But that’s only true if you’re buying calls on individual stocks and/or with short times to expiry. Buying in-the-money index LEAPs, for example calls on SPY or QQQ out to 2021/2022, would be a relatively Bogley way to index invest with leverage.
Ryzen
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Re: Why are Call Options a bad idea?

Post by Ryzen »

I agree that LEAPs could have a place in portfolios, but most people hearing about options from their buddies, their buddies aren't talking about LEAPs.
runninginvestor
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Re: Why are Call Options a bad idea?

Post by runninginvestor »

Another point about buying call options instead of purchasing a stock, is you pay more for the stock that way. For example (someone feel free to correct me if I am wrong!):

Apple is trading roughly $117. If you think it will increase to $120 but have to pay $1.50 premium for the call option, you won't make money until the price of Apple goes above $120 + $1.50 = $121.50. Even if the stock went to $121, you're still down $0.50 per share. But 1 option contract is leveraged to 100 shares so you are really down $0.50 * 100 = $50. If the option is exercises in the money at $121 in this example, you bought 100 shares of Apple stock for $120 with a cost basis of $121.50.
JackoC
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Re: Why are Call Options a bad idea?

Post by JackoC »

nasrullah wrote: Tue Sep 15, 2020 9:47 am I was in a conversation with a buddy yesterday who's long call options (+ margin leverage) on a few stocks he's tracking. I get why the margin leverage and I understand that risk/reward (or likely in his case just the gambling fix). What I walked away with wondering is why not purchase call options? If you want to purchase a stock and the company doesn't pay dividends, what's the disadvantage of purchasing long calls vs just the stock?

There's the cost to purchase the options and the cost for the position so the downside seems fixed and limited. But any significant movement upwards is multiplied using options right? I feel like I'm missing something major here.
"Few stocks" implies a stock picking rather than indexing approach, where the consensus here and my own belief is that indexing is generally better.

As other post mentioned, you could buy calls on the index rather than investing in it outright. You can't actually say that violates BH principals. It's inaccurate IMO to call it 'market timing' or 'active management' if done on the basis of fixed rules. As you say, buying calls means you have upside and pay a fixed amount (each period you buy an option) in lieu of the downside of holding the underlying. You could do that for the same notional size as you'd otherwise invest in the underlying and the result would be less risk, and correspondingly in an efficient market, less return.

However historically, strategies which substitute *selling* of options on the S&P for holding the S&P have had higher Sharpe Ratio, the relationship of excess return over 'riskless' to std dev of return. PutWrite: you *sell* one month at-the-money puts on a given notional of the S&P monthly rather than holding that same notional amount of the S&P. Return from inception (late 80's) to date has been lower for a given notional size as would be expected since risk is less, but std deviation of return enough lower for Sharpe Ratio to be noticeably higher. This is an 'anomaly' in a mean-variance world though not necessarily an 'inefficiency' because the standard assumption of 'modern finance' that only return and std dev of return matter is not necessarily entirely realistic. Although, PutWrite has also been less negatively skewed than holding the S&P, shallower maximum loss historically. At least one ETF runs on this idea, but the extra expense ratio in 'idea' ETF's is often bigger than whatever advantage the idea might have. On a DIY pre tax basis there isn't an obvious argument I know why PutWrite is a bad idea though. Considering taxes, getting profit from writing options is often taxed more than buy and hold of underlying, and doing it in an IRA might be impractical due to higher margin requirements a broker would impose on sold options in an IRA v taxable. But tax situations are individual.
http://www.cboe.com/products/strategy-b ... -index-put

On a simple technical point you raise, the value of dividends is built into options (and futures) prices: there is no issue of forfeiting the value of dividends because you use a derivative to be long the underlying rather than just buying it.
ChrisBenn
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Re: Why are Call Options a bad idea?

Post by ChrisBenn »

The issue with buying long calls (from an investment point of view) is the extra premium you are paying for the downside insurance (i.e. the optionality in the option). If your investment horizon is far out then you are never really going to take advantage of that downside protection, hence it's a waste.

Rolling the option forces you to realize gains every year also, though at least you can do it at the LTCG rate (vs deferring indefinitely (until liquidation) for the underlying equity holdings)

The only reason really to do it (buy long term calls) is for leverage, and currently margin rates at IB are lower than the effective rates on deep in the money SPY options (about as liquid as it gets).

Granted I don't think something like 2 year leaps rolled at 1 year are "bad", rather they are just less optimal than other mechanisms for security exposure.
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Re: Why are Call Options a bad idea?

Post by firebirdparts »

I think the fundamental answer has been given; they cost extra and they expire. However, deep in the money calls could be used as a stock substitute within reason. They cost more and are not volatile, so as you’d expect, the risk and reward Is more like stock, and it gets more boring as you go deeper in the money. Like everything, there’s no free lunch. They have advantages and disadvantages.

Like Ryzen thought about LEAPS, I figure people talking at the water cooler aren’t talking about buying calls with a strike price at half the underlying.
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CardinalRule
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Re: Why are Call Options a bad idea?

Post by CardinalRule »

runninginvestor wrote: Tue Sep 15, 2020 10:56 am Another point about buying call options instead of purchasing a stock, is you pay more for the stock that way. For example (someone feel free to correct me if I am wrong!):

Apple is trading roughly $117. If you think it will increase to $120 but have to pay $1.50 premium for the call option, you won't make money until the price of Apple goes above $120 + $1.50 = $121.50. Even if the stock went to $121, you're still down $0.50 per share. But 1 option contract is leveraged to 100 shares so you are really down $0.50 * 100 = $50. If the option is exercises in the money at $121 in this example, you bought 100 shares of Apple stock for $120 with a cost basis of $121.50.
If you were interested in a LEAP (say January 2022), the premium would be a lot more than that. You would pay more like $19 (or $1,900 for one 100-share contract. So AAPL could rise by 15% by January 2020, and you would lose your entire option outlay (in addition to giving up several quarters of dividends). Of course, AAPL could rise by 15% next month, in which case you would have a big gain on your call option. As others have mentioned, the time element is key for options, along with volatility.

If I were to buy 100 shares of AAPL at 117, I might be tempted to sell a 2022 LEAP with a strike of 140, for perhaps $12. But as call writer, I would probably be more inclined to write a shorter-dated call, with a lower strike. Time decay can be a wonderful thing, depending on which side of the coin you are on. :wink: Lately my limited options activity has been on SPY only, mostly writing puts but sometimes covered calls. I addition to SPY's breadth, I like the liquidity and relatively narrow bid-and-ask spreads for SPY options.
hunoraut
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Re: Why are Call Options a bad idea?

Post by hunoraut »

long options is basically playing roulette. win big, lose fast. edge goes to the house (in this case, options writer).

good for a bit of fun or as a tool in the portfolio. never as a core strategy
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Re: Why are Call Options a bad idea?

Post by bmritz »

hunoraut wrote: Wed Sep 16, 2020 9:05 am long options is basically playing roulette. win big, lose fast. edge goes to the house (in this case, options writer).

good for a bit of fun or as a tool in the portfolio. never as a core strategy
Why does the “edge go to the house” in this case? Naively I’d think that “efficiency of the market” and “Nobody knows nothing” would dictate that the average market price would compensate you for the risk and “long odds of hitting the lottery.”
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Re: Why are Call Options a bad idea?

Post by bberris »

I don't think buying call options is a ridiculous move. Not optimum, but not absurd. You could be a very conservative investor with a huge bond allocation and buy options with the interest. This is the "never lose money" strategy employed by fixed index annuities. I wouldn't do it though.
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Re: Why are Call Options a bad idea?

Post by Chuck »

bberris wrote: Wed Sep 16, 2020 10:05 am This is the "never lose money" strategy employed by fixed index annuities. I wouldn't do it though.
Because it ignores the very important question, "compared to what?" (Thank you, Thomas Sowell.) It's easy to "never lose money" when measured in nominal dollars, but that's a silly baseline. You should be at least using the risk-free rate, and that leaves little to nothing left with which to buy calls. The "never lose money" strategy is actually risking the nominal bond returns on options bets.
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Re: Why are Call Options a bad idea?

Post by abuss368 »

We sold a lot of covered calls back when trading individual stocks. One strategy was to turn a non dividend paying stock into a dividend paying stock by selling a call.

I really did not enjoy it and it felt like speculation.
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Re: Why are Call Options a bad idea?

Post by JBTX »

While it depends on the strike price, and how much in or out of the money you are, but buying call options is like starting with $1.00, flipping coins 10 times, each flip you either lose the dollar or double your money. In that case there is a much bigger than 50% chance that you will lose your $1.00 investment, and a much smaller than 50% chance you will win, but win big.
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Re: Why are Call Options a bad idea?

Post by hunoraut »

bmritz wrote: Wed Sep 16, 2020 9:09 am Why does the “edge go to the house” in this case? Naively I’d think that “efficiency of the market” and “Nobody knows nothing” would dictate that the average market price would compensate you for the risk and “long odds of hitting the lottery.”
the price is not efficient relative to risk.

the variable component in option premium is the implied volatility. historically, implied volatility has been higher than actual volatility, for any meaningful period of time. so the options tend to cost more than their risk-adjusted value.
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Re: Why are Call Options a bad idea?

Post by Ryzen »

hunoraut wrote: Wed Sep 16, 2020 12:32 pm
bmritz wrote: Wed Sep 16, 2020 9:09 am Why does the “edge go to the house” in this case? Naively I’d think that “efficiency of the market” and “Nobody knows nothing” would dictate that the average market price would compensate you for the risk and “long odds of hitting the lottery.”
the price is not efficient relative to risk.

the variable component in option premium is the implied volatility. historically, implied volatility has been higher than actual volatility, for any meaningful period of time. so the options tend to cost more than their risk-adjusted value.
Also the theta of the option decays exponentially the closer the option gets to expiration, which is why longer-dated options have a higher premium to compensate the seller for the longer time period. Every day (theoretically, every infinitesimally small unit of time) an option is not assigned the odds move further towards the seller since the other "greeks" have to move sufficiently to offset the theta decay. That could either be a larger move in the underlying or an increase in IV.

Also, in my opinion from having experienced the options market, the options market is not all that efficient. Markets might be efficient on a long time frame experienced by the typical Boglehead index investor, but some of the minute-to-minute swings that can have huge effects on options are not always efficient. Case in point - Kodak recently or the infamous VW Short Squeeze that made Volkswagen the most "valuable" company in the world for a short time in 2008.
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Re: Why are Call Options a bad idea?

Post by hunoraut »

Basically, even as the market has had this continuous bull run dating back to March, i've been selling covered calls (nominally a bearish stance) against my shares, and it's been nice.

Sell them far enough out of the money, you get benefit of the underlying growth of the equity, AND collect a cherry on top from the options if contract remains out-of-money.
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