Advantages of Trading Options Over Stocks
In the investing world, trillions of dollars worth of shares are bought and sold each day on the major exchanges all over the world. On any given day, traders and investors can take part in the purest form of capitalism by putting their money at risk by buying into any of the major global corporations across the planet in the pursuit of profit. Yet, there is another way of speculating: trading options, which can be far superior to just trading the shares of a given company.
Understanding Options
An option is a derivative on an underlying security that gives the right, but not necessarily the obligation, to buy the underlying security at a given set price. They come with different strike prices, expiration dates, and allow tremendous leverage as each option controls up to 100 shares of stock in a particular company. These advantages make options a far superior trading instrument than just trading stocks.
Leverage in Options
One advantage is leverage. Leverage is the ability to use a small amount of capital to control a huge asset. Like in real estate, where a small down payment allows a prospective buyer to control a huge piece of property, options allow the trader to control up to 100 shares of stock with just a tiny bit of capital, referred to as the option’s “premium” which is the actual cost of the option.
Example of Leverage: If you notice that ABC stock is set to rally higher and is trading at $50 a share, you can buy 100 shares for a total of $5,000. A few weeks later, if ABC stock rallies to $60 a share and you sell all your shares, you will have profited $1,000 or a 20% return. Not too bad.
But a friend of yours sees the same setup in ABC stock and decides instead to buy an option with a $50 strike price which is priced at a $2 premium for a total cost of $200 ($2 X 100 shares = $200). If ABC stock rallies to $60, your friend sells his $50 strike option for $1,200, resulting in a 500% return! That’s the power of leverage when trading options.
Generating Income with Options
Another advantage is that a trader can generate income by using credit spreads with options. If you see that ABC stock is in a trading range and is staying above support at around $50 a share, you can create a credit spread by creating what is called a Bull Put Spread. You sell the current month’s $50 put option and pocket the premium received, and then purchase the current month’s $45 put option for insurance in case the stock plummets unexpectedly. Then sit back and let the options reach their expiration date and you collect the difference between the premium received for selling the $50 put option and the cost of purchasing the $45 put option.
Shorting Stocks with Options
A third advantage is that options also give you the ability to short stocks without the restrictions of short-selling stocks. When you short a stock in anticipation that it will go down in price, you not only have a larger cash outlay versus buying put options, but you also have to pay interest on the stock you borrowed to short plus the dividends the stock might pay during the time you hold it. With put options, you avoid all that, plus you can make faster returns since stocks often fall twice as fast as they rise.
Risk Management in Options
The most important advantage is that the most you risk is the actual premium you paid for the option itself. If a stock gaps up or down on news and you’re on the other side of that trade, you only risk a small amount of your capital, whereas if you had bought the stock, you could lose half your position overnight. For example, early in 2006, Google reported strong earnings but not as great as Wall Street had expected and the stock was pummeled. Then a few weeks later, Google’s Chief Financial Officer spoke publicly about a temporary pullback in their future growth and the stock plummeted. If an options trader were long Google call options at that time, that trader would have only lost a small portion of their overall trading capital versus someone who had bought the stock itself.
Conclusion: Maximize Your Investments
The advantages listed here are only a few compared to the dozens that options afford traders who are disciplined enough to learn them. Stocks have been likened to playing the game of checkers, while options are compared to chess due to the tremendous opportunity and flexibility they offer traders and investors.
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