Options or stocks? Most stock traders and investors have an uneasy relationship with options. There is a whole new lingo for options trading, and it’s viewed as “too risky.” Yet the media loves options traders who make millions with risky trades like GameStop (NYSE:GME).
All the hype aside, If you already actively trade stocks or at least invest in the stock market, you should have a solid understanding of options. It’s important to have as many tools in your toolbox as possible.
In this article, we’ll compare options vs stocks, reviewing the advantages and risks of each instrument, and will outline general trading strategies for both stocks and options.
What Are Stocks?
Stocks are shares of ownership of a company. When you buy a stock, you become a stockholder or a partial owner of the company.
The stock’s price provides an immediate valuation of the company that issued the stock. Because there are lots of factors that affect the company’s business and its profits, the stock prices are volatile.
Stocks are liquid, which means they are easy to buy and sell at the market price. Of course, some stocks are less actively traded, but compared to owning a private company, any public company is liquid.
This liquidity and volatility make stocks an attractive instrument for price speculators.
Advantages of Owning Stocks
Stocks can generate returns via capital gains or through dividends. They have several advantages over other financial instruments, including options, such as:
- Historically higher returns: Over the long term, stock prices go up as companies grow with the economy or raise prices for their products in line with inflation.
- Income from dividends: some companies pay dividends, and that could be a great source of income.
- No pressure to sell: Even if the share price collapses right after you bought, you don’t need to sell and can safely (and potentially profitably) wait for years for the market to turn.
- Easy to buy and sell: Stocks are liquid, and they are more liquid than options or other derivatives that are based on their prices. Each stock is represented by a ticker, and there is just one price.
Risks of Owning Stocks
If you hold stocks, you likely already know the risks, but let’s still recount them:
- Price volatility: Stock prices can go up and down a lot. It could be nerve-wracking to watch that if you have big speculative positions.
- 100% loss potential: Although that’s not very likely (especially with the current ultra low interest rates), any company can go bust, and then the company’s stock would go straight to zero.
- Dividend cuts: Unlike with bonds or and other fixed-income instruments, there is no guarantee that dividends will be paid in any particular year.
Strategies for Stocks
Trading strategies for stocks are only limited by traders’ imaginations. Yet at the highest level, traders and investors either seek capital gains or aim to get income from dividends. The multitude of strategies could be divided into three broad categories:
- Short-term active trading for capital gains: You buy shares at a lower price and sell at a higher price. Or you can short sell shares that you don’t have by borrowing them from your broker and then buying them from the market at a lower price. This second approach is called shorting and is very risky. In either case, you aim to make capital gains over a relatively short time frame.
- Long-term holding for capital gains: You can also simply buy and hold stocks. Over the long-term, stock prices go up as companies grow with the rest of the economy. While individual companies and their stocks might underperform or even go bust, on average, stocks do well over longer time frames.
- Long-term holding for dividend income: Long-term investors aim to buy shares at attractive valuations and then hold them to collect dividends.
What Are Options?
Options are derivative instruments that give the buyer a right to buy (for call options) or sell (for put options) the underlying asset, usually shares of a company, at a specific price by a certain date.
On the other hand, option sellers or underwriters must sell or buy the shares if the options buyers exercise the option.
Options were invented to manage risks. If you’re afraid that the share price will go down, you can buy a put option and sell your shares to the option seller if the price goes down.
Most options traders, however, use options for price speculation. But before we dive into use cases for options, let’s get clear on the parameters that are unique to each options contract.
Characteristics of Options
For each stock there could be a wide range of different options contacts. Each option contract specifies:
- Premium: That’s the current market price of the options contract.
- Type of option: There are two types of options — calls and puts. Call options give you a right to buy the shares, and put options give you a right to sell shares.
- Strike price: That’s the price at which the option can be exercised, i.e. at which you can buy or sell the underlying shares.
- Expiration date: That’s the date by which you can exercise your option or otherwise it will become worthless.
Because options have expiration dates, the period of time for trading options is shorter than for stocks, which can be held for an unlimited time. Expiration dates for options could be days, weeks, or quarters away.
Depending on the current price of the underlying stock and the strike price, the options could be:
- Out-of-the money: The current share price is below (for calls) or above (for puts) the option’s strike price. This means at these prices it would not be profitable to exercise the option, i.e., buy or sell the underlying stock. These options are cheapest because it’s likely that the option will expire worthless.
- At-the-money: The current share price is equal to the strike price. These options are more expensive.
- In-the-money: The current price is slightly above (for calls) or below (for puts) the strike price, which means the option could turn an immediate profit. Of course, in practice, the price of such options equals or exceeds the potential profit from the immediate exercise.
On your brokers’ website and around the internet, you can also find the so-called option Greeks: delta, gamma, vega, theta, and rho. These are different measures of options risks that professional options writers and speculators use to manage their positions. In general, the more volatile the stock, the more expensive the options (both calls and puts).
Advantages of Options Trading
While options are undoubtedly complex, they have several important advantages compared to buying stock.
High Potential Returns Through Built-In Leverage
You only pay the premium, and for call options, your returns are potentially unlimited, while for put options, they are only limited by the price going to zero.
For example, let’s imagine GameStop’s share price is now $270. You think it will go to $370 in a week.
If you’re right, your profit would be $100 ($370 minus $270). Your return would be 37% ($100 divided by $270, then multiplied by 100).
Let’s imagine an at-the-money option (i.e., with a strike price of $270) costs $50. If you buy that option and the share price hits $370, you could exercise your option and buy the stock for $270. The profit would be $50 ($370 minus $270 minus $50). Yet your return would be 100% ($50 divided by $50, then multiplied by 100).
When you buy options, you only risk the premium (the price you’ve paid for the option), which could be lower than if you buy the underlying stock and the price moves against you.
In our example above, with a call option, you’ve risked $50, the money you’ve paid to buy the option.
Yet if you buy the actual stock, your risk would be higher. For example, in May 2021, GME’s price was around $170, and in February 2021, it was under $50.
Skilled options traders can find profitable opportunities in any market because they can profit not only from the price volatility but also from volatility itself — the more volatile the stock, the more valuable the options are, both calls and puts.
Risks of Options
While options could be very profitable, the risks are high as well.
Options require a higher risk tolerance, and if watching the stock market prices is already emotional for you, then options would be even more stressful.
- 100% loss risk for option holders: Your option could expire worthless, and the sum you’ve paid to buy it is lost completely.
- Unlimited risk for option writers: When issuing and selling options, your risks are potentially unlimited, while your potential gain is limited by the premium the buyer pays. That’s a very risky strategy that should be left to market makers.
- High complexity: The Greeks are there for a reason — because the price of options is affected not only by the market price of the underlying stock but also by the price volatility of that stock. This means that even if the price moves in your direction, your options positions could still result in a loss.
These risks, however, are only relevant for active trading. If you buy options to protect your stock holdings, then you’re actually paying to transfer the risk to the option writer.
Strategies for Options
Now that we’ve covered the technical stuff and the risks, let’s look at options trading strategies that can help traders make money:
- Buy call options betting the stock’s price will go up: If you expect that the share price will go up before the option expires, you can buy a call option, risking only the premium and profiting from the price increase, which could result in higher returns compared to just buying the stock.
- Buy put options betting the price will go down: Similarly, if you expect the share price to go down, you can buy a put option. Unlike with short-selling the stock, where your potential loss is unlimited (if the stock’s price surges), your risk is limited by the premium you’ve paid.
- Buy both call and put options to profit from volatility: If you expect the price volatility to rise (for example, the price might move a lot before or after a major announcement), then you can profit from buying both an out-of-the-money call and an out-of-the-money put option, which is known as a strangle. Basically, if the price breaks out in either direction, you profit.
- Buy put options for hedging the risk of a stock price crash: This is also known as a protective put because you buy both the stock and the put option, which protects in case the share price goes south — the put’s profit then compensates the loss on your stock position.
Dip Your Toes in Options Trading
While options trading might seem complicated and risky, it could be a great way to make capital gains with a small part of your portfolio and achieve your financial goals faster. And the best way to learn about options is to get some skin in the game and try trading yourself.
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