1. What are the Pros and Cons for using options as a direct substitute for the underlying, Theoretically? 2. Do you think the theoretical Pros and Cons that you know are really useful, Practically? 3. What are the trade-offs in general, when using options instead of the underliers? 4. Most importantly, have you improved your trading performance after the substituting process (or just giving-up)? Profitability %, or Smoother curve, or both? Thanks!
There is probably a book's worth in answering those. Pro for me is that they are NOT a direct replacement.
Pro: You can get more Delta for less money. Con: You are subject to the rigors of a supply and demand market for the options. This means that the options can make or lose money just because of their own trading, namely Implied Volatility. Yes, I do. For example, if I hold the opinion that the price SPY or QQQQ will be substantially higher by the end of 2010, I could purchase LEAPS at the money, and just hold those. I could also take the cash I would have used to buy those ETFs and place them into a risk free investment, like a CD, savings account or similar. If that opinion holds true, I will realize lower but substantial gains than a pure investment in the ETF. If I am wrong, then I only lose a relativily small amount. In this example, I am not trading, I am investing. In my example, you are trading a smaller gain for protection, the classic hedge. I sleep better. HTH Steve G
You question is ambiguous I think... Do you mean using options as a replacement for a stock? ex: I buy calls on SPY if i think its going to go up. Or Do you mean using options to create a synthetic position that would be equivalent to having bought SPY. Those 2 things are very different, they do not have the same risk, not the same reward and basically nothing else is the same. In a nutshell: One of the main advantage of the first strategy is of course leverage, you need less money to be exposed to the underlying. Big draw-down: time decay, in the end you will make a loss even if the stock as laid still... The second strategy converts any interest or dividend into capital gains, which is a big advantage tax-wise. A big disadvantage is more commissions = higher buying price than just buying the underlying.
Long options: Limited cost/loss Lower margin Leverage Lower delta so less bang for the buck per underlying $ move Change in implied volatility (may help or hinder) Time decay erodes your position Timing: they expire
Great answer the only thing I would add is slippage in the options and having to cross two markets for the pure synthetic
I have read about in the money leaps being used as surrogate have read it is a close substitute if the premium is all intrinsic value. Here is the article I am referring to. I am doing this with EEM in a virtual account and have had some good success http://www.investopedia.com/articles/optioninvestor/04/021104.asp
Isn't there an interest rate built into the LEAPS and won't interest rate moves affect them? You know the whole no free lunch thing...
A deep ITM leap is not always easy find. Donât forget the further out in time you go the closer to .50 deltas all the options get. You'd need a really really deep ITM option to get close to 1.00 deltas and then you'd incur a huge bid/offer spread and if the underlying moved you'd also be subjected to huge Vega risk. Thats in addition to the Rho risk mentioned above.