Equity markets have seen major pullbacks and extreme volatility recently, sending investors in search of ways to protect their investments. Kim Parlee speaks with Bryan Rogers, Client Education Instructor, TD Direct Investing, about options strategies that may lower your risk when trading.
- It has been an incredibly volatile time on the markets. And while some options strategies could be considered risky, some actually help reduce some of that risk. For more, we're joined by Bryan Rogers. He's client education instructor with TD Direct Investing.
And please note that this information is for informational purposes only. It does not provide financial, legal, tax, or investment advice. Securities-related information displayed or mentioned is purely for discussion purposes only.
Bryan, I've gotten the disclaimers out of the way. And let's start with the basics. Nice to see you. What are options? And how do they differ from stocks?
- Well, Kim, buying a stock, you're going to pay the full price. So if it goes up or down, you're still paying that full price per share, where buying an option can be more like a deposit or paying a fee to lock in a price to buy or sell in that matter. So you can do either/or. I've never confirmed this, Kim, but I believe options are named "options" because they provide more options. I never confirmed that 100%.
- I think that seems-- that's very logical. And it's a good way to remember it. Let me ask you. More options in this kind of market is actually pretty important. Can you just give an example of maybe why-- how we should think about it given what's going on today?
- Well, the markets right now, they're all over the place. And we have increasing interest rates. A lot of people are worried about that. We have inflation worries. And that's created a lot of volatility. So it could provide new opportunities, even where stocks might be a little bit undervalued. One way you can use options is you can use it in place of buying the stock, so if you didn't have enough money to buy that 100 share. We'll look at an example a little bit later.
But longer term, call options can mimic a stock purchase with a lower upfront cost. Also, they can be used-- on the flip side, they can be used when there's a downturn in the market. And you can use it like insurance as well, so you can also profit from a downturn. And you also protect your holdings as well.
- And for someone who's just starting, where's the easiest place to start?
- Well, for me-- it could be different for others. But for me, I first learned buying a call option. And the reason I think that one's the easiest for people to start is because it does translate or it relates to that idea of buying low and selling high, what we learn with stocks. With call options, you're giving yourself-- you're locking in that price to be able to buy the stock at a specific price.
So we have the stock price increases-- you can sell that in itself at a higher price. Or you can even elect to go ahead and then buy the stock at that locked-in price. So maybe the stock is appreciated or gone up in the interim. And then you have that ability to-- they call it exercise. So you can actually take your right and now buy that stock at that lower locked-in price. So in either event, the faster the stock moves up and the higher it goes, the more money you're going to make.
- So, Bryan, what's the biggest risk, the maximum risk, to that strategy?
- Yeah, Kim, unfortunately, there is a downside. There's always a downside in anything with investing. But the downside for options is the fact that you could lose 100% of the investment. And the other thing that goes along with that is there is a time frame, too. So something has to happen within that certain time frame.
So you have a deadline with an option, where you can hold the stock kind of ongoing. Sometimes people like the fact that there is that deadline. They know they're paying that lower cost, and they have that expiration. But that could be considered as a disadvantage as well.
- I think one of the best ways to show people how this works is to use an example. So can you give us an example?
- Yes, yes, I don't know if you're the same as me, Kim, but my kids hate it when I drag them to Home Depot in the spring. So in honor of them, I'll give you a Home Depot example.
All right. But if we go back to the spring of March 2021 and you wanted to buy 100 shares of Home Depot, it was trading at that time at $260 a share. So buying 100 shares, you would have to pay $26,000 US to buy those, that 100 share lot of stock. So the potential option to use instead of that or a potential strategy to use instead of buying the stock would be buying a call option.
So at that time, the $260-- because you can pick whatever range you want. But let's say if you happen to pick around that certain price-- they call it at-the-money price. You can pay $14, which represents about $1,400 cost for you because it's on a per share basis. And every option represents 100 shares, so the total cost of $1,400 for an 80-day expiration.
So as we all know already-- this is going as a historical example-- Home Depot, at that time, rose within that 80 days to $315. So in this case, you make a profit by selling the option for the difference. So that $260 locked-in price you had, you can now sell the option for $55 because there's that total difference.
You paid $14, or $1,400, if you're doing the total, so that worked out to a profit of roughly around $41 per share within that option or $4,100. The same thing would have happened with the stock if you'd bought the stock. But remember, you would have had to paid $26,000 upfront, which is a lot of money. Maybe you wouldn't have had that, or you didn't want to risk that. You would have made around $55 or $5,500 total with the stock.
And as you can see up on the screen on that bottom line, that's about a 21% return on investment, so 55 divided by 260, or 5,500 divided by our 26,000. Whereas with the option, we only paid $14 so that goes into an astounding return on investment of 292%, Kim. So I think that's definitely a good benefit of options.
KIM PARLEE: That's a nice number. I've got about 90 seconds here. But we got to talk with the other side. That's when it goes well. What happens if it goes in the other direction?
- Well, once again, that maximum risk is the option could be deemed worthless, they call it. So in that time frame if the stock didn't go above $260 in that 80 days, then you could lose 100% of your investment, and you would lose that $1,400.
KIM PARLEE: And there you go. It's very clear what the downside is. Lots of upside, but, of course, the downside is pretty finite on that one. I know you're coming back next week, Bryan, on the show. We're going to keep talking a bit more about options and some of the strategies people can think about.
But I also want to remind everybody that TD Direct Investing is holding an Options Month in June, very exciting, where the audience can join in. So maybe tell us quickly what Options Month is about.
- Yeah, I'm really excited, too, Kim. The entire month is dedicated to live interactive training. So you can go live classes yourself. You can go to webinars, things like that. So we've got something for everyone at all skill levels. And yeah, it'll be for the entire month, so from beginner to advanced. And if you want to register, you can go to www.td.com/oem.
KIM PARLEE: Awesome. Bryan, thanks so much. We'll talk to you again soon.
- Thanks, Kim.