A remarkably popular article on SA this week is the trade of the year. The author boasted of having achieved 650% returns thanks to his purchase of call options of Apple (AAPL). In fact, the strategy was slightly more complicated but it is beyond the scope of this article to analyze this method in depth. As many experts have boasted similar profits with the use of call options, it is only natural that many investors will be tempted to follow this strategy. However, investors should be aware of the great risks of this strategy.
First of all, as a side note, the profits mentioned in the above article are false and misleading. For instance, in the case of Apple, the capital at risk is not $8000, on which the 650% return has been based. The actual capital at risk is $8000 plus $151,000 (=2000*(85-9.5)). This is the case unless you have a guarantee that the stock of Apple will not fall below the strike price of the put options ($85). Therefore, the actual profit is 52,000/159,000 = 32.7%.
When investors purchase call options instead of buying shares of their desired stock, they essentially choose to highly leverage their returns. However, they should realize that there is no free meal in the market and, in fact, leverage is a two-edged sword. While it greatly increases the profits in the positive scenario, it also multiplies the losses in the adverse scenario. For instance, when investors buy an at-the-money call option and the underlying stock falls or remains flat, all the invested capital is lost, i.e., the trade results in a 100% loss. On the contrary, when investors purchase a stock and the stock falls, the losses are limited while they are also mitigated by the dividend payments. The contradiction between shares and call options becomes even more pronounced if an investor buys out-of-the-money calls. In that case, all the invested capital is lost even if the stock rises up to the strike price of the call on its expiration date. Consequently, investors should realize that call options have an entirely different risk/reward profile from stocks.
Even if the call option does not expire worthless on its expiration date, it is still hard to make a profit from it. Most investors underestimate the impact of the time decay of options on their returns but they should not ignore this critical factor. More precisely, buyers of call options suffer from the erosion of the time value of their options. Every day that passes by, the time value of options decreases. Therefore, in every boring session, buyers of call options lose money while, of course, they also lose money in all the negative trading sessions. Consequently, to make a profit, buyers of calls need the underlying stock to rally really fast from the moment they initiate their position.
Therefore, great timing is required for this strategy to prove successful. Unfortunately, experience has proved that the market is so unpredictable in the short run that no-one can consistently time the market. Even Warren Buffett and Peter Lynch have repeatedly admitted that they cannot time the market. And while some investors boast of having timed the market once, they certainly cannot repeat this on a regular basis. Therefore, they should not follow this strategy, which strongly depends on market timing due to the fast erosion of the time value of the options.
Investors who have a long-term perspective should not replace their stocks with their call options. If they do, they will keep paying the option premiums year after year and will thus greatly hurt their returns. Even worse, they will forgo the dividends distributed by the underlying stock. In other words, buyers of call options incur a double hit, which results from the payments of the option premiums and the forgone dividends. This double hit can easily devastate the returns of a portfolio in the long run.
To provide a perspective, those who prefer to buy at-the-money annual call options of Coca-Cola (KO) instead of its shares forgo 3.2% annual dividends while they also pay an option premium of about 2% on the current stock price. Therefore, they lag the annual returns of the stock by about 5.2% per year. It is important to note that the cost of the strategy would be much higher if the volatility were not near record-low levels right now. Some investors will claim that buyers of call options can use high leverage to enhance their returns and outperform S&P (SPY), as call options require much less cash than shares. However, the use of high leverage on a regular basis is not a recipe for success; instead it is a guaranteed recipe for disaster in the long term.
To sum up, when investors hear some experts boasting of astronomical profits, such as the ones mentioned in the above article, they should realize that such profits are too good to be true. Buying call options has great risks, as most of the invested capital is lost in most outcomes. The strategy requires excellent timing and an impressive rally of the underlying stock in order to outperform the alternative of just purchasing the stock. Finally, investors should never follow strategies that have time working against them.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.