V.11:11 (445-450): Equivalent Option Strategies by Lawrence G. McMillan

Equivalent Option Strategies by Lawrence G. McMillan

Stock option traders and futures option traders may think they're already outsmarting stock and futures traders by trading options against their stock or futures positions, but Larry McMillan, author of Options As a Strategic Investment, suggests you take another look: Substituting options for a position in the underlying instrument may be the more efficient alternative. This article presents a simple way to compare alternative options strategies. See what you could be doing.

One of the advantages of options is that they are versatile. Options can be a speculative vehicle or a risk-reducing vehicle. In this article, we'll look at some simple uses of options that can increase your trading efficiency in terms of capital usage and execution without requiring an understanding of complex options strategies.

When options are combined — that is, assuming more than one option position at a time — the profit potential that results often resembles that of a more traditional trading position but may be more efficient in one of several ways. The key to determining how to compare option combinations with more traditional positions (such as a long stock) is to understand how to determine when two strategies are equivalent. Experienced option traders know that understanding equivalent strategies or positions is vital. By establishing the more favorable equivalent strategy, the trader may be able to use his capital more effectively or get a better execution when trading.

Two strategies are equivalent when they have the same profit potential — that is, their profit graphs have the same shape. Two equivalent strategies will most likely have vastly different margin requirements, but their ultimate profit or loss potential is the same in dollars and thus, their rates of return may be substantially different. Almost every strategy using call options, for example, has an equivalent strategy using put options. (In most of the strategies discussed here, futures may be substituted for stocks.)

Let's look at an example. The purchase of a call option is equivalent to the simultaneous purchase of common stock plus a put option. Both strategies have profit graphs with the same shape (Figure 1). Both have unlimited upside profit potential and limited risk. Of course, the call purchase requires a much smaller initial investment and has a loss potential of up to 100%. The combined stock and put purchase has a much larger investment, but the potential losses and gains are much smaller on a percentage basis than those of the call purchase.