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Options are Better than Stock (Part 3)

I believe I am already done if I were simply trying to argue that options are less risky than stock.

I have shown the naked put position to outperform long stock if the underlying trades down, sideways, or up “a little.” In the previous example, AAPL stock could trade up over 10% in one year and still lose to the naked put. I also argued for higher consistency of returns with naked puts over long stock. This means lower standard deviation of returns and lower volatility of returns. In this case, it also meant lower maximum drawdown for the option position.

All this suggests option strategies are a better choice for a large segment of stock investors. Options are more suitable for growth investors. Options are also more suitable for income investors given the non-refundable premium collected up-front.

I would say neither options nor stocks are suitable for “safety investors” who are most concerned with capital preservation. This may include the elderly and people in retirement. This does include the extremely risk-averse. For this group, Treasuries, highly rated corporate bonds, or certificates of deposit would probably be a better fit. I think the option position can lose less than the stock position but when the market gets really ugly both can lose significantly.

The one category more suitable for stock than options would seem to be speculation. This involves stock selection with the hope of hitting a home run rather than singles and the occasional double. In the following graph, the blue line represents long stock and the red line represents a covered call position:

Long stock vs. CC (upside considerations) (9-13-16)

The yellow highlighting indicates that when the market races higher, the stock can outperform. The option position has limited upside potential whereas the stock has unlimited upside potential. This is a reason why many people like to buy stocks. For some it is like the lottery: people hope to see their shares double, triple in price—or more.

I could argue that options (e.g. long calls) also outperform stocks to the upside. Unfortunately, though, I cannot implement options in such a way to outperform in bearish, sideways, and mildly bullish conditions and also outperform in strongly bullish ones. And if I implement options to outperform in strongly bullish conditions then I would underperform were the market to trade slightly higher or sideways (although I would outperform were the market to move significantly lower).

I will wrap all this up in the next post.

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