Really I can sum up this entire article in one sentence: because options can produce huge returns with far less capital. But, let’s delve more into why you might want to trade options over stock. At Option Zoo, we mostly trade options and we generally don’t do the fancy stuff like spreads, iron condors, butterflies, straddles, strangles and whatever other crazy thing you can think up. As a general rule, you’ll find these trades offer a whole lot of risk with very little reward! Hey, I’m not discouraging you from doing it, in fact, we may even recommend it when it makes sense.
On our site, we don’t spend a lot of time teaching you specifically what an option is because there is a plethora of videos and tutorials all over the internet to teach you. We focus more on the psychological aspects of trading.
Let’s first talk quickly about why options are considered so risky. It’s because they expire. They can go worthless and you can potentially lose every penny. It sounds much scarier than it really is. When you choose wisely and manage your positions, your chance of loss is minimal and we’ll get more into all of that in a minute.
Stock does not expire. You can hold stock as long as you want, but there is still the risk of a company going bankrupt or being delisted and potentially costing you every penny as well.
Let’s look at the biggest reason for trading options over stock. Options can produce infinitely greater returns than stock at a mind boggling rate. In our example, you can see if you buy 100 shares of stock you’re tying up $5,000. Whereas with options, you’re buying 1 contract which is essentially equal to or represents 100 shares of stock. Except we aren’t interested in actually buying the stock. We’re only buying the right to purchase the stock at the strike price of $50. As the price of stock rises so does the option contract, when the contract is “in the money” it will start to move dollar for dollar with the stock. Buying only the option in this example would net you a $300 return or 60% profit on only $500 versus only 10% or $500 buying the stock.
There are other price factors involved like the time premium, volatility and others. But the price of the call option will always be worth at least the amount of the difference between the stock price above the strike price. And it is essentially the reverse for puts.
I don’t know about you, but I like a 60% return over 10% any day with a fraction of the cost!
Now let’s look at the flip side of why options are riskier and why it’s important to understand this. As with anything, the greater the risk the bigger the reward, well as you can see with options, it’s easy to get hung up on the huge returns without remembering the potential downside. When the stock doesn’t go your way, your potential for greater loss is also very big. We bought the stock at $50 and it fell $5, losing 10% or $500 in value on $5,000 invested. The option contract will also fall in price until at some point it can become almost worthless. In this case if we bought the option it would be a loss of 60% or $300 but on only $500 invested. That’s more than half, but even with the potential for bigger losses there are still many reasons you want to trade options instead.
Yes the loss was technically bigger on the option contract, but you were using much less cash. So in your transaction with $5,000 dollars you lost $500, but with the option contract, you only lost $300. You were not putting out as much money to begin with, therefore, in some sense your risk was less(I’m sure many would argue otherwise).
If you have a small account or you just don’t want to trade with large amounts of cash, then options are the way to go. Using options, a $5,000 account can make the same kind of returns as a $50,000 account trading stock. But don’t go out and just start buying any old stock option thinking you’re going to become a millionaire overnight. It’s unfortunately not that easy and in my early days, I lost my entire account trading options. So what do you buy? What is the secret to making more money with options and growing your account? Well number one I recommend you read this article. And number two, this is also where our premium membership can help. We have a proprietary system of stock picking we’ve developed over years of observing stock behavior and noticing very specific patterns in certain stocks. Our system can help you become a better trader and make better decisions. Check it out here.
Disclaimer: Trading options or securities is risky. We do not guarantee results and ultimately the decision to buy and sell is up to you.