Stock options are often demonized as recklessly risky investments. Others tout options as useful tools for managing risk in a portfolio. An aspect of stock options that isn’t discussed much is the frictional costs of commissions and spreads in stock option investing.
The people I have known personally who have dabbled in stock options have been burnt badly. They approached options with a gambler’s mentality and lost. This is enough to justify the advice many give to stay away from options unless you are an expert or are getting advice from an expert.
On the other hand, if used correctly, stock options can reduce the overall risk in a portfolio. There is no free lunch, though. If the portfolio risk is lower, then the expected return is lower as well.
An aspect of stock option investing that has always concerned me is the high friction. Frictional costs are the costs associated with trading in and out of stock or option positions.
When I buy or sell stocks or ETFs, I pay a visible $10 commission. A less visible cost is the spread between the bid price and the ask price. The bid price is the highest price someone is willing to pay for the stock, and the ask price is the lowest price someone is willing to sell the stock for.
The spreads on stock options are much higher than the spreads on stocks, and stock option investing usually involves more trading than direct investing in stocks, which costs more in commissions.
An Example: RIM stock
Suppose that I wish to own 200 shares of RIM stock. As I write this, the current quote on RIM is
If I make a market order for RIM, I would pay the ask price. The total cost of buying 200 shares of RIM would be 200 shares times $52.02 per share plus the $10 commission for a total of $10,414.
When the time comes to sell the shares, with a market order I would get the bid price. My total frictional costs would include the two commissions plus the bid-ask spread. The two commissions cost $20 total, and the 2 cent per share spread on 200 shares would cost $4. So, the total frictional cost is $24.
Another Approach: RIM Options
As I write this, the current quote on the Montreal Exchange for September 2009 RIM options struck at $52 is
The first thing to observe is that the bid-ask spreads are about 100 times the spread on RIM stock. Another minor consideration is that (at my discount broker) commissions on option trades are $10 plus an extra $1.25 per option contract. A contract corresponds to 100 options.
To properly compare direct stock ownership costs to option trading costs, we’ll use what is called put-call parity. It turns out that if you own an at-the-money call option and short an at-the-money put option at the same time, it is the same as owning a share of the stock, except for a few differences I’ll discuss in a moment.
So, if we buy two call contracts and sell short two put contracts on RIM, it is about the same as owning 200 shares of RIM. If RIM shares go up, you’ll get this upside with the call contracts, and if RIM shares go down, you’ll pay for this from the shorted put contracts.
The main differences between owning the stock and taking the option approach are frictional costs, dividends, tax treatment of gains and losses, the possibility that the put option gets exercised early, and margin requirements for writing puts. But the gains and losses from movement in the stock price are the same.
Let’s look at the frictional costs of the option-based approach more closely. We’ll assume that the put option doesn’t get exercised early, and that we will close out the option position just before the options expire. If RIM stock has gone up, this means selling the call option and letting the put option expire worthless. If RIM stock has gone down, this means buying back the put option and letting the call option expire worthless.
We will be making 3 option trades with a total of 6 option contracts traded. At $10 per trade and $1.25 per option contract, this is a total commission cost of $37.50. Things get worse when we consider the spreads.
We had to pay the ask price of $10.90 (see the quotes above) on the call option, and received the bid price of $8.70 for the put option. The net cost per option is $2.20. Multiply this by the 200 options of each type, and the total spread cost is $440.
The final trade to close out the option position would have a much lower spread because options on the verge of expiring have a more predictable value. I’ll assume an additional $20 in friction to close out the option position. This brings the total frictional costs to $497.50.
So direct stock ownership costs us $24 on a roughly $10,000 investment and achieving the same thing with options costs nearly $500, or 5% of the stock investment. This is a huge expense ratio over only a 6-month period. Continuing to own the stock costs nothing more, but the option investor will pay another $500 every 6 months.
The moral here is that while options have their place for knowledgeable investors to manage risk, frictional costs can be substantial and must be taken into account.