Trading options versus stocks can be a very different experience as options are contracts and stocks are equity ownership in a company. Options are derivatives written on an underlying stock with an expiration date and a pricing model based on the probability that the option expires in-the-money. A stock is a small piece of ownership in a public company that can entitle voting rights for the shareholder or pay a dividend from company profits.
Option contracts are not investments in a company. Options are diminishing bets correlated to probabilities inside the options expiration. They are bets on an asset reaching a specific price within a specific time frame using a contract.
Options vs Stocks Returns
While most stocks in the short-term only tend to go up 10% – 20% at most, an option contract can increase 50% to 100% or more depending on how far out-of-the-money the option is and the velocity of its move closer to being in-the-money.
Stocks have a floor price based on the value of the company while a stock option can expire worthless and go to zero if it expires out-of-the-money. While the returns can be triple and quadruple digits with options they can also go to zero for a total loss of capital used to buy them.
Why Buy Options Instead of Stocks?
Option contracts can allow a trader to control more shares than buying shares of stock.
Option contracts limit losses of capital to the price of the contract.
Options allow a trader to make a diverse amount of different types of bets on price action and volatility not just up or down.
Options can supercharge percentage returns on capital with the right option plays.
Options provide leverage for smaller accounts.
Pros and Cons of Options Trading
While most stocks can be traded with adequate volume on major stock exchanges, an option trader has to be careful to only trade option chains that are liquid and have tight bid/ask spreads to avoid losing money in getting in and getting out of trades. Liquidity is the most important fundamental in options trading. Front month and the options closest to being in-the-money provide the tightest bid/ask spreads.
While stocks will retain some value based on the company’s value, options can be all or nothing bets resulting in the loss of all capital used in an option trade.
Stocks can only be used for directional bets up by being long or down by being short. Option plays can be structured to bet on many different types of scenarios and not just direction. An option trader can bet on price trends in any direction, the magnitude of that trend, price ranges and the time periods, increasing volatility, decreasing volatility, specific prices being reached or not reached by a date, and many other scenarios. Put options can be sold at the strike price that a trader wants to buy a stock for. Call options can be sold on a stock holding at the price a trader of investor wants to sell their stock for. Options open up many new trade scenarios for traders.
I have created the Options 101 eCourse for a shortcut to learning how to trade options.
