Let me start this blog post with a question. . .If you're going to buy a house from me, would you rather just buy the house outright OR have a contract to buy the house at some predefined price in the future?
Naturally you might think that the next questions you would ask are "What's the value of the house now?" and "What do you think the value will be in the future?"
If the value of the house now is $100,000 and you can only buy it in the next year for $105,000 then maybe it's not a good decision. Or maybe it is a good decision - who knows! Maybe you think the value of the house is going to go up more than that in the next year, and you'll be purchasing it for below market value?
Let's Help You Make This Decision A Little Easier
This type of question gets to the heart of trading and investing when we talk about buying the underlying shares, or buying the option on the shares. There's a lot that goes into this decision that you have to make as an investor, but these topics will help make it easier.
First, we're going to start looking at technical analysis. As always, technical analysis will give us some leading indicators that will help us make this decision easier.
If we use things like MACD, Stochastic, and Bollinger Bands we can get a good idea of where we think the underlying stock may or may not go in the future. And what's great about all of these indicators is that you can get a pretty good estimate of how long it may take for the stock to reach a certain price range.
Time Is. . .Well, Money
The decision from there is going to be based upon one thing, and one thing only, and that is how long is it going to take that move to happen? For options, time is a wasting asset.
If you think that a stock right now could move up 200%, but it may take five years to do that, then you might go for buying the underlying shares. If you think the stock could move in any direction after earnings but you just don't know which direction that's going to be, then you may actually go for buying the option on the stock instead of buying the underlying shares.
Stocks Offer Unlimited Time To Profit
Before you make a final decision you have to understand the benefits of each choice. With stock purchases, you have the benefit of time on your side. There's no wasting asset. The value of the stock is what it is every day and you can hold it as long as you want.
You get to enjoy the dividends, but you also have the risk that the company may go bankrupt and lose value dramatically overnight. As always, the additional benefit comes with another form of risk.
Options Offer Massive Potential But Are Time Sensitive
With options the benefit is you keep all the upside potential without the downside risk. This is particularly the case with a call option, where you keep all the upside potential of the call option, but limit your downside investment to just the premium you outlaid.
If a stock goes bankrupt the next day, you don't lose all your money. Instead you only lose the premium you invested. The downside to options is that they are time-specific and price-specific. So not only do you have to be right in the direction you're guessing of the market, but you have to fairly certain of the timing and the magnitude of the move.
What Factors Do You Use To Make This Decision?
So now that we've gone over all of this, what helps you make the decision easier? Add your comments below the post, and let me know what you guys think helps make the decision easier when you decide on buying the underlying shares or buying option. Is it purely technical based? Do you never buy the shares? Do you always buy the options and possibly buy the shares in the future?
Leave us a note and let us know.