If I am buying a stock why don't just I buy an in the money option?

Question

I'm a 15 year stock market investor here who is very new to option trading (two weeks). I have a full understanding of how options work (complicated needless to say) and I have realized their potential.

I have read that is not a good idea to hold the options until expiration or to exercise them but it does make sense to me to hold them if I have enough money to buy them. I am using Robinhood so there are no commissions or fees.

Let's say that I plan to buy VUG in a couple of weeks when I get paid. I can buy a two week call now and if it is above the break even price in a week and half, why don't I just leave it as is and wait to purchase the shares? I already buy shares every other week and I already made a profit for buying the option earlier.

Every single comment I have read on the internet states that I should not exercise. To me, since I am a buy and hold investor, it makes sense to purchase stock that way. Am I missing something?

Answer 1

The reason that it is recommended not to hold long options until expiration is that option premium decay is non linear. It speeds up every day, faster and faster as expiration approaches.

The reason that it is not recommended to exercise ITM options is that if there is time premium remaining, you throw it away by exercising. So unless the time premium is pennies, it's usually a better idea to sell the option and execute the trade in the underlying. The exception to this is when you own a deep ITM option and the bid is less than intrinsic value, but that's another story.

Your approach is a special situation. You want to buy the underlying at later date but you want to lock in the price now by using a long call. That's a valid approach. The question is, should you be buying a two week call?

Since you didn't indicate the strike price and premium for the call that interests you, I'll just pick my own. Strike prices near the money have the greatest amount of time premium and ITM options have less. So for example, here are some July calls (VUG does not trade offer weekly options):

VUG $201.00

$175c 28.50 203.50 2.50

$180c 24.00 204.00 3.00

$185c19.70 204.70 3.70

$190c 14.90 204.90 3.90

$200c 7.40 207.40 6.40

The numbers above represent the strike price, the ask price of the call, the net cost of the stock and the time premium. As you can see, the lower the strike, the lower the time premium. You pay dearly for buying the less costly ATM strike.

VUG options are not actively traded and they have low Open Interest. Therefore, they have very wide bid/ask spreads. With some patience, you should be able to buy these for less. Start at the midpoint (the average of the bid and ask) and work your way up if you want the position and you are willing to pay more.

An alternative approach if you have the appropriate option level approval, a margin account and enough marginable securities to back the position would be to sell a short put. With this strategy, you would receive the premium and time decay would be in your favor. There's no guarantee that you would get the shares at a locked in price (buying the call) and then you would just earn income (the premium).

This may make your head hurt but if you combine both of the above, you would have a synthetic long position (sell the ATM put and use the proceeds to buy the ATM call). Let's say that it costs a dollar to do so. If VUG rises, you exercise your long call for $200 and your net cost is $201. If it drops and you are assigned on your short put, you pay $200 and your net cost is $201. That's a significant savings versus buying a long call.

Answer 2

If stocks have worked for you in the past, and if you don't have a very large amount of capital relative to the notional value of the options that you will trade, I think you should stick to stocks. The main issue with options is that each option contract is on 100 shares. If you would not buy or sell at once 100 shares of a stock, you should think several times before trading options on that stock because every time you are trading an option you are making a commitment to buy or sell 100 shares of the stock at one price. Another issue is liquidity. If liquidity is poor, you should stay away from that option unless you plan to hold it to maturity.

It is very hard to make profits consistently on options. Making money once or twice does not count. As for your example, if the stock price is above the strike price at option expiry you do get to buy the stock at a discount but note that you need to deduct the premium you paid for it from the discount. The discount has to be reasonably larger than the premium for you to make a decent profit. Also, you have to be able to cough up money for 100 shares at once. Much better would be to dollar cost average by buying fewer than 100 shares at any given time. Also, the time value of options tends to decay. That does not happen with stocks.

There is a good chance that you will lose your hard earned capital gains over the next few months if you are not discreet with the use of options. In my view, if you don't have large amounts of cash, it is best to stay away from them.