How Using Options Can Provide Higher Investment Returns Than Stocks

Updated on August 29, 2018
Daniel Mollat profile image

Daniel is a retired business executive who now devotes most of his free time to trading stocks and stock options in the stock market.

At many gatherings of friends and business associates, the conversation may sometimes turn to a discussion of what is the best investment for capital. There are those who are adamant followers of investing their capital in money funds such as bank savings and Certificates of Deposit (CDs) contending that they can sleep soundly knowing they will never lose their money no matter what.

Many more find CDs to be extremely low paying and prefer higher returns such as bonds and mutual funds. Then there are more aggressive investors who find investing in stocks the best long-term investment for capital growth and income.

Indeed, history has shown that over many years the stock market has provided the best returns for capital invested.

Stock Market Trading Floor

Source

At one such get-together, the conversation gravitated to an animated discussion between two groups of stock investors: those in the options trading game and those doing purely stock investing. The options traders claim that stocks alone may not be as good an investment as stocks are complemented with options.

I led the pack of those strongly advocating the use of options as an excellent investment instrument.

The other group, stock investors, felt that options are too risky and should be avoided in a portfolio of stocks. If the reader of this article has never explored options as an investment tool he/she would very likely agree immediately with the stock investors group.

But as it has already been shown in many articles, some of which are my own, as well as numerous books and websites, options can be extremely good investments whether used alone or in conjunction with stocks. Of course they can also be extremely risky if used too aggressively and recklessly. Just like reckless investing in dubious stocks can be very risky.

Complementing stock investments with options is a far safer strategy than investing in stocks alone without options. I’m a strong proponent of the belief that over the long term investing in options alone, even without stocks, delivers better returns than stocks alone. In the world of stock market investing, options alone can be used as one of the best investment strategies in place of stocks.

The strategy is to sell put options against one’s cash position instead of investing the money in company stock. Perhaps the best way to explain this is to illustrate an actual experience I had many years ago.

The Challenge

In 2013, in one of our gatherings, the discussion came around to the subject of how good are options really? As always, I was the strongest supporter of options investing, arguing my way around people who were strong believers in stock investments. Among those in the group were members of an investment club that invested heavily in stocks. After much discussion one of the club members came up to me on a private aside.

Author being challenge by investment club member
Author being challenge by investment club member | Source

He asked if by using options to complement their stocks the club could generate better returns that they were disappointingly achieving. I replied that by selling call and put options they would definitely get better performance. He was skeptical about my claim and asked me to show him how the technique of selling options will increase the club’s investment returns over a given period of time.

He asked me if I would be willing to do options trading on the same stocks that the club would invest in and show them what the results would be after several months of investments.

The request was posed to me in such a way that it appeared to be more of a challenge than a serious request for assistance. The club members were still of the mindset that options trading is extremely risky and should be avoided. They expressed serious doubts that I could do better than them and wanted to see actual proof of my being able to outperform them.

I accepted the challenge and the contest was on.

The plan was that I would follow the stock they selected to purchase but I would be using options in most if not all my trades. I would only buy the actual stock if it became absolutely necessary as a consequence of my options being exercised or assigned.

It was agreed that we were each to start with the same amount of cash capital investment. They would use their cash funds to buy stocks while I used mine to trade options on the same stocks that they purchased. I would confine myself to trading mostly put options all the way and only get into stocks when absolutely necessary. I would only trade call options if I got into a situation where I had to own stocks.

After a given period of time, we would compare how each of their stock selections performed against my option trades on the same stocks.

Our trading adventure lasted some nine months from August 2013 to June 2014.

The Results?

The club's total portfolio of selected stocks ended up with a net loss of $4,849.

I generated a total net profit of $698 trading options on the same stocks they selected.

Here is a summary of our trades:

CLIFF NATURAL RESOURCES (CLF): In August of 2013 they purchased shares of Cliff Natural Resources at a price of $22.82. At the same time, I sold put options on the stock and continued trading options (buying and selling) for as long as the club held on to the stock. In December of the same year, they liquidated their holdings at a price of $24.55 for a gain of $865. They received a total of $225 in cash dividends raising their total profit to $1,090. Per agreement I had to liquidate my options positions when they closed their stock position. My net profit was an astounding $2,299.69 after commissions/fees.

WESTPORT FUEL SYSTEMS (WPRT): In the same month as above the club bought shares in WPRT at a price of $28. I followed by selling put options on the same date. Shortly after our entry into this security the stock started dropping and continued its downward trend until April 2014 when the club decided to cut their losses and liquidate their position. The price was then at a low of $13.77 with the club absorbing a total loss of $7,115. No dividends were paid by the company. I too took a loss of $3,545, a much lesser loss than they did.

VANECK VECTORS GOLD MINERS (GDX): The investment club bought into this ETF in December of 2013 at a price of $20.95. I followed suit by selling put options on the same date. They held the ETF for five months and in May 2014 they liquidated their position at the price of $23.39. Including dividends of a measly $95 their total gain amounted to $1,315. I didn’t do as well with a gain of only $524.

SPDR S&P METALS AND MINING (XME): The club bought into this ETF in August 2013 at $37.19 and held it for ten months until June 2014 when they closed the position at the price of $38.70. Their total gain for the ten months, including dividends, amounted to $1,018. My options trading produced a total gain of $1,439.

ISHARES MSCI EMERGING MARKETS (EEM): This is another ETF which the club entered at a price of $42.06 in November 2013. They kept the stock for only four months and sold out in March 2014 at a price of $39.38 for a total loss of $1,340. They received dividends of $183 thus reducing their loss to $1,157. By comparison, my options trading sustained a small loss of only $24.

TOTAL FINAL TALLY:

Investment Club: negative $4,849

Options: positive $698

Are Options Therefore Always Better Than Stocks?

I would be lying if I answer this question in the affirmative. No, options are not always better than stocks but in the world of stock market investing, over the long term and with a diverse portfolio of stocks or options, options will, more often than not, emerge the winner.

When does stock investing outperform my system of options trading?

When a stock is in an uptrend continuously for a fairly good length of time it will render a better yield than using my system on the same stock.

Here is an example. In August 2013 Verifone (PAY) was at a current price of $20.34 when I started trading options on this stock. Its price went steadily up from $20.34 to a high of $30 in January 2014. I continuously sold covered puts while the price persistently kept going up. By March it was at $33. At this point if the stock investor liquidated his PAY stock he would have exited with a profit of $12.66 against my options gains of $9.68.

But if we prolonged the time frame on this stock what could have happened?

From June 2014 PAY’s stock price went on a trading pattern, dancing up and down within a range of $34-$38 until May 2015, a period of eleven months. After this date, the stock made a sharp turn-around and started dropping precipitously down to a low of $21 in the following nine months.

Assuming the stock was not sold in March when it was at $33, with the stock investor continuing to hold on to it until May 2015, and assuming I too continued to sell options regularly as each option expired on the same stock, my gains would have certainly overtaken any appreciation gained and lost by the stock investor within the eleven month period.

At the end of eleven months, the stock was at almost the same price as it was in August 2013. The investor who held on to the stock in all this time would have ended with nearly zero appreciation value, while I, the options trader, would have continued to accumulate gains from my options sales.

In conclusion, unless one is an expert stock timer who never fails to time the market correctly every time, all the time (a near impossibility), investments in stocks will not beat pure options trading in delivering higher returns over time.

New to Options?

Start your options education by reading books, articles and visiting websites on the subject of options. For starters, I highly recommend the book "Options Trading: Strategy Guide for Beginners". This book is short enough to enable the newbie to get started in no time at all. One important feature is the section on how to avoid mistakes in the options business.

NOTE:

Any and all information pertaining to trading stocks and options including examples using actual securities and price data are strictly for illustrative and educational purposes only and should not be construed as complete, precise or current. The writer is not a stockbroker or financial advisor and as such does not endorse, recommend or solicit to buy or sell securities. Consult the appropriate professional advisor for more complete and current information.

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    © 2018 Daniel Mollat

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