Is Option Trading Safer Than Stock Trading? Discover the Key Points
Options have been around for many years, but their popularity has started to grow exponentially only in recent years.
In the past, investors have avoided options as they felt they were tricky to understand. Many people have had negative experiences with options as they weren’t properly trained on how to use them. As with all investing tools, not knowing how to use them can lead to severe problems and negative outcomes.
Options have also had a reputation for being risky and dangerous, two words associated with them in the financial media, adding to this bad reputation. This has led investors to steer away from options and mainly focus on traditional stock investing and trading.
Despite the above, there are several great advantages to options trading when compared to regular stock trading. I'll explain each in more detail down below, but before then I want to make a quick introduction about options.
What Are Options?
Options are financial derivative instruments, meaning they refer to the price of another asset. In the case of options, the underlying asset can be a stock, an ETF, or even an index like the S&P500 or the Nasdaq 100. For simplicity, in the following examples I will refer to options on stocks.
Options are contracts between two parties, a buyer and a seller.
By purchasing an option contract, a trader obtains the right (but not the obligation) to buy or sell the underlying stock at a price that has been agreed upon, on, or before a specific date.
By selling an option contract, a trader assumes the obligation (receiving a premium for it) to buy or sell the underlying stock at a price that has been agreed upon, on, or before a specific date.
There are only two basic kinds of options available.
A call option gives the option holder the right (but not the obligation) to buy shares of stock at an agreed price on, or before, a particular date.
A put option gives the option holder the right (but not the obligation) to sell shares of stock at an agreed price before or on a specific date.
The agreed-upon price, which I have mentioned several times, is known as the strike price. The particular date I have referred to is known as the expiration date.
So, what does this all mean? Let me give you a couple of examples.
You have bought a call option at a strike price of $100 that expires in 30 days. As long as you are within those 30 days, it means you can buy the stock at $100 per share. This will remain the case even if the price goes up above the strike price, which is a profitable outcome.
Another example is if you choose to buy a put option as a protection measure for stock shares you already own. This means that you can sell the shares at the strike price at any time during those 30 days. This is great because even if the stock price goes down by a lot, you can still sell it at $100, giving you a much better selling price than the current market value and reducing the loss on the stock position.
Advantages of Option Trading Vs Stock Trading
After a quick explanation of what options are and how they can be used, let's review some of the main benefits of options trading compared to normal stock trading.
Options have good leveraging power and can be very cost-effective. Investors have the opportunity to get hold of an option position that is similar to a stock position but with much less capital.
An option contract can almost replicate the equivalent value of a stock but uses less capital with a lower upfront cost. The goal is still to participate in the gain (or loss) of a particular stock, but with less money at risk.
However, for this to work, the options need to have a high delta value. These are deep in-the-money (ITM) options, which means the option has a strike price that is relatively above the market price of an asset (in the case of a call option) or relatively below the market price of an asset (in the case of a put option).
There is also a specific options strategy that allows you to exactly replicate a stock position with a so-called synthetic stock position. Let me give you an example.
Let's say a stock is trading at $50 on the open market and you believe the stock will move higher over the short term. The traditional alternative is to buy shares of the stock and hold them, waiting for the stock price to grow. In this case, to buy 100 shares, you will need to allocate a capital of $5,000. That, for some people, could be a quite substantial amount of money.
As an alternative, you can buy 100 synthetic shares of the same stock. To do that, all you have to do is to buy one at-the-money (ATM) call option contract at the $50 strike price, and simultaneously sell an ATM put option contract at the $50 strike price, both with the same expiration date.
The combination of the long call and short put in a single position will replicate almost exactly the ownership of 100 shares of the underlying stock if bought at the current market price of $50 per share. The potential gains and losses will be identical to those of the stock position, but the capital required to open the options position will be much lower.
The main downside of options when trying to mimic a standard stock position is the expiration date. When you own shares, there is no time limit, and potentially you can hold them forever. On the contrary, every option contract has an expiration date, and you have the position to go in the right direction before expiration. If that doesn't happen, you normally lose money and have to close or adjust the position before expiry.
As with any other trading strategy, traders must know what they are doing for this approach to be really cost-efficient.
Higher Potential Returns
The flip side of the previous point is that options also allow for higher potential returns. Some also refer to this as the multiplier effect on returns.
This is because, as long as the trader has selected the right stock, strike price, and expiration date, the option can pay the same profit as it would for standard stock ownership but with a much lower capital investment.
As traders are getting options at a lower price but the return would be the same as it would be for the stock, then that would mean a higher potential return.
While there are situations where trading options can be riskier than trading equities, there are times when using options can greatly reduce risk.
For example, options can act as a hedge against potential drops in the price of stocks. If an investor is worried that the price of certain shares he owns is going to drop, he can buy a put option, which gives him the chance to sell that stock at the strike price, even if the market price drops significantly below that price before the expiration date.
If an investor manages to do this, he has hedged himself against losses, therefore minimizing his overall risk. However, it's essential to remember that, in general, all investments come with a risk, and returns are never guaranteed.
Guaranteed Stop Loss
Aside from being lower (as we have previously seen), the risk of an option position could also be guaranteed.
In normal stock trading, when you open a position you can set up a stop-loss order that, in theory, could protect you against sudden market moves in the opposite direction. However, especially when the moves are very strong and quick, or when the stock opens a trading session at a price different to the one at which it closed the day before (this is referred to as a "gap"), these stop losses may not be guaranteed at the price you previously set up. So, in this case, the realized loss will be higher than the one you expected when opening the position.
On the other hand, for option strategies that have a defined risk, the maximum loss is always guaranteed no matter what the intensity of the stock move or what's happening when the market is closed. This is a great benefit of using options that can allow a trader to really make a proper risk mitigation plan that remains valid independently of what might happen in the market.
Of course, there are also a number of options strategies where the risk is not defined, and could be the same as a stock position or even higher than that. As always, education is the key element for every trader to understand what to do and how to become successful.
More Strategic Alternatives
The last advantage I’ll be discussing in this article is that options offer more strategic alternatives. As they are very flexible, they can recreate synthetic positions, which gives investors the opportunity to achieve the same investment goals in a number of ways.
For example, if an investor wants to short a stock, they may have a broker who will charge a margin, which can be quite prohibitive. Other brokers may not allow for the shorting of stocks at all.
This leaves stock investors with the inability to play the downside. However, with options, this is easily attainable by just buying a simple put option or creating a synthetic short position (buying an ATM option and simultaneously selling an ATM call with the same expiration date). Brokers do not have any rules when it comes to investors buying puts to play the downside, making this a very big advantage in the world of trading.
At the same time, when a stock is moving sideways for a period of time without generating significant changes in price, it's almost impossible to make a profit with traditional stock trading. On the contrary, there are a number of excellent strategies that allow you to generate consistent profits during a stock price consolidation pattern. Basically, with these strategies, you make money when the stock doesn't move much over a certain period of time. This is another significant advantage for options trading when compared to traditional stock trading.
There are several advantages to using options when it comes to trading, making option trading safer than stock trading. However, if you are thinking of using options, you must ensure to educate yourself thoroughly, as things can go wrong if you don’t know what you are doing.
You should also remember that all kinds of investments come with risks, and although options are a great way to limit risks and profit in different market conditions, you must know how to do this properly.
Before getting involved in options trading, you should carry out some thorough research and perhaps find some more experienced traders available to train and mentor you.
Gaining advice from someone who has been involved in options trading, can give you a good insight into how it all works, and how you can be successful with it.
Remember that the options are financial products that carry significant risk. If you have no trading experience, you should seek out professional investment advice before putting any money at risk. Each individual investor should evaluate his or her financial situation and investment objectives before selecting an investment strategy and getting involved in options or stock trading. Potential losses in option trading can exceed the invested capital.
All the content is published and provided for informational and entertainment purposes only. None of the information contained in the content constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. You understand that the Content Creator is not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy, or other matter. All of the information contained in the content can not be considered to be investment advice. Such information is impersonal and not tailored to the investment needs of any specific person. Make sure you have checked with your financial advisor and tax accountant to make sure you are suitable to execute what is discussed on this website.
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