Reasons to Trade Options instead of Stocks
What are the reasons to trade options instead of stocks? People who start with trading usually start with buying shares. The classic way you make money in the stock market is to buy low and sell high.
Of course, there is always the possibility that you will buy high and sell low, but it also can result in a loss. To make profits with Stock options you need to have a reasonable amount of money and choose several stocks.
Own a part of company with Stocks
Every share of stock represents an equal amount of ownership in a company. Owning stock gives you the right to participate in the company’s growth and to share in its losses. There are two primary ways to make money with stocks. You can sell your stock for more than you paid for it to generate capital gains. There is always the possibility that the market price of your stock will decline, so there are definitely some risks associated with buying stock. Thus our probability of making a profit (whether short or long) on a position is 50%. This is why the coin toss is an appropriate analogy for the stock market.
What are Options
So, why should you trading options instead of stocks? You can limit your risk while maintaining unlimited potential gains by investing in stock options instead of stock. You have more possibilities to make money.
An option does not give you ownership in the company, but it does give you the right to purchase or sell a specific number of shares of stock at a set price, called the strike price, for a set period of time. Options are traded at a fraction of the price of the underlying stock. Once an option reaches its expiration date it becomes worthless and ceases to exist. If the price of the underlying stock drops like a rock, your risk is limited to the amount you paid for the option. If the price of the stock goes through the roof there is no limit to how much money you can make on your option. Another way is to sell out of the money options. You receive Option Premium for selling the OTM option. Than you will wait that it expires worthless. You can keep the credit you have received.
Reasons to Trade Options
Why do we like Stock Options? With Options you can create better odds. Stocks has a 50% chance to make profit. A study done using Chicago Mercantile Exchange (CME) data showed 83% of all options on stock indexes expired worthless. This is how the sellers make profit. We can use this information to our advantage. If you sell out of the money options you may keep the premium when the option expires worthless. How can you do this? Select options with the right probability of success. By selling Options with 17 Delta you have 83% chance that you can keep the credit that you have received.
Stock Options have great leverage. A Trader can buy an option position that will mimic a stock position almost identically, but at a huge cost savings. For example, in order to purchase 100 stocks of Apple which is trading for $104, an trader has to pay out $10,400. However, if a trader bought one $20 call, one contract represents 100 shares, the total amount of money payed would be only $2,000
Buying a stock option is less risky for the trader because they require less financial commitment than equities. On the other hand selling naked options can have certain risk though, therefore the rewards are better. You can reduce the risk by selling spreads instead of a naked options.
Stock Options have Higher Potential Returns. You don’t need a calculator to figure out that if you spend much less money and make almost the same profit, you’ll have a higher percentage return. When they pay off, that’s what options typically offer to investors.
Use stock option for Strategic Alternatives. The final major advantage of options is that they offer more investment alternatives. Options are a very flexible tool. There are many ways to use options to recreate other positions. We call these positions synthetics.
By selling stock options it is possible to make money even when the stock doesn’t move. For example: after the stock rallied you sold a call stock option. The price is just above the stock market price. For a while the stock doesn’t move much. The premium goes out of the stock option and if it stays that way until expiration you made money for just selling the call.
What about the Risk?
Of course, option selling is not without risk. Taking steps to put probabilities in your favour does not mean you cannot lose money. The theoretical loss on an option sold uncovered is unlimited, you can sell spreads though to limit the risk.
There are many reasons to trade options instead of stocks. You do not have to have a big capital to start with. You can make bigger returns, and create trades with a high probability of profit. It is possible to reduce risk and make money even when the stocks does not move.