For stock traders that are new to options, one of the most common questions I get is:
“Are options safer than trading stocks?”
It’s important to note both stock trading and option trading have risks, and while many the risks in trading both of them are the same, some of the risks differ substantially.
In this article, we’re going to explore some key topics, such as:
- Are options riskier than stocks?
- Why are stocks riskier than trading options?
- Are options more profitable than stocks?
- Why options are better than trading stocks?
- And should you trade options?
Let’s dive into the listed topics. I’m confident for those of you that read this whole article, you’ll find some major differences between option and stock trading, and why you should look into options.
Are Options Riskier Than Stocks?
The answer to this question is both yes and no, but when done right, options can be less risky than trading stocks?
Why to yes, no, and how can options trading be less risky than stock trading?
As to how trading options can be riskier than stocks, it’s important to understand there are major differences between trading stocks and options.
Trading stocks is like playing checkers – the rules are simple, not that complex, and there’s only a few ways you can move.
Trading options is like playing chess – there are more rules, more ways to move, and more combinations to win.
With trading stocks, you can only make money in two directions, bullish or bearish. But with trading options, you can make money if the market is bullish, bearish, you can make money if the market ranges, you can make money without caring about direction (trading both bullish and bearish), you can make money via time passing, volatility increasing or decreasing, and you can make money via options getting repriced.
This means there are absolutely more ways to make money trading options than simply being bullish or bearish. That’s good for making money and having more strategies, but it also means there are more ways to lose money. Hence, it can be said that in one way, trading options can be ‘riskier’ than trading stocks since there are more ways to lose money (as well as make money).
Hence, it’s important you understand all the ways you can make and lose money trading various option strategies.
With that being said, let’s jump to the next topic.
Source: Wance Paleri
Why Are Stocks Riskier than Trading Options?
When you trade stocks, you can only buy or sell the stocks, meaning it’s very binary how you make money, you’re either bullish or bearish.
But the problem with these limitations (only being able to buy or sell stocks) is there’s no way to ‘hedge’ or neutralize the risk while maintaining a long or short stock position.
When you trade stocks, if you are bullish and you want to neutralize the risk on your long stock trade, you can only close the position. A stop loss limits the risk, but it doesn’t ‘neutralize’ the risk.
Hence, if you want to keep a long stock position, but the stock is going down, you are stuck with only two options. Keep the position as it declines and lose money on your long stock trade, or close the trade. That’s it!
But with options, you can be long a stock trade and also long or short an option which allows you to neutralize some or potentially all of the risk should the stock decline. This does not require you to close your long stock position, so you can keep it if you’d like.
That’s a major advantage to trading options as it allows you to reduce or neutralize the risk on your long and short stock trades without having to close the stock trade or position.
That’s a major advantage, especially if you’re a long term buy and hold investor. Instead of just watching your long stock portfolio lose money, you can buy or sell options to reduce/neutralize the risk on them, potentially even profiting while the stock market declines.
And that is a major advantage of trading options and stocks versus just trading stocks. Hence, in many ways, trading stocks can be riskier than trading options.
Are Options More Profitable Than Stocks?
It’s important to understand that there are many ways trading options can be more profitable than trading stocks. For example, when you trade stocks, say you buy 100 shares of Apple stock ($AAPL).
For every $1 move the stock goes up, you only make $100 (100 shares x $1 = $100). THAT WILL NEVER CHANGE, no matter how much the stock goes up. It will always be a $100 gain per $1 move up in the stock when you buy those shares.
Hence the amount you make will always be fixed based on the number of shares.
But with options, the amount you make when a position goes in your favor, say when you buy a call option on Apple, can actually increase in profit for every $1 increase in the stock price.
This is because options have what is called a ‘delta’, which is the variable that determines how much your option’s value increases for every $1 move in the stock.
But here’s the secret…when you buy a long call, the delta (assuming it’s less than 1.0) will increase for every $1 move the stock goes in your favor.
This means your option can increase in the amount of profits you make the more and more the stock goes in your favor. It is only until your delta reaches a value of 1.0 that your profits will not increase more for every $1 move the stock goes in your favor.
Hence, if you buy 100 shares of Apple stock and it goes up $10, you can only ever make 100 shares x $10 = $1000. And keep in mind you have to put up a large amount of margin to buy Apple stock.
So if Apple is trading at $150 per share, you’ll have to put up $1500 for your 100 shares of Apple.
But if you buy a call option on Apple for $1.50, you can put up a lot less capital. 1 Call option on Apple for $1.5 = $150 (1 contract controls 100 shares, so 100 shares x 1.50 for the call option = $150). So you can control the same amount of shares in Apple for only $150, which allows you to have more capital to make other profitable trades.
But it gets better. Let’s say this call option on Apple costs $1.50 and the delta for this option is .50, and has a gamma of .05 (gamma = the amount the delta increases per $1 move in the stock).
If Apple stock goes from $150 in price to $151, your $1.50 option is now worth $2.05, or $205. Why $2.05? Because the $1.50 price for the option + the delta (.50) + the gamma (.05) = $1.50 + .55 which = $2.05 with a delta now at .55.
Hence if Apple then increases from $151 to $152, your $2.05 option is now worth $2.65 ($2.05 + .55 delta + .05 gamma = $2.65 or $265 with a new delta of .60).
When Apple goes from $152 to $153, your $2.65 option is now worth $3.30 ($2.65 + 60 delta + .05 gamma = $3.30, or $330.
Hence by trading options, you more than doubled your money ($150 to $330) with only a $3 move in Apple stock. If you had traded only the 100 shares of Apple, your profits would only be $300 on a $1500 investment, which is a 20% return. Hence, you have the potential to make more money trading options with the capital invested than buying an equal size stock position.
That is the power of options – you get better leverage and can make more per $ invested for an equal size stock trade.
Thus, option trading can be more profitable than stock trading.
Source: Wance Paleri
Why Options Are Better Than Trading Stocks?
Besides the reasons listed above, there are more reasons why trading options are better than trading stocks.
For example, you cannot receive a credit just for buying or selling a stock to start a stock trade. You have to pay money to buy or sell stock shares to initiate a trade.
However, with options, you can ‘sell’ options (like a car insurance company sells car insurance) in exchange for receiving a credit for selling that option.
When you sell an option, that ‘credit’ is immediately applied to your account, which means you can use those profits to make other option trades.
In essence, for taking on the risk of writing (selling) the option, you get a credit into your account. If the option you sell ends up worthless to the buyer (and a lot of them do end up worthless to the option buyer), then you get to keep the full credit.
It’s very much like a car insurance company selling you car insurance, and you not getting into an accident that year. They get to keep the full ‘premium’ of that credit you paid.
On top of this, you can make money by being bullish and bearish on a stock at the same time. Don’t know if the stock is going up or down, but believe it’s going to move a lot soon? You can make an option trade that will profit if you’re right, regardless of whether it moves bullish or bearish.
You can also make money by volatility increasing or decreasing, like it often does before and after earnings.
Simply put, there are way more ways to make money trading options than stocks, hence we think options are better than trading stocks as more ways to make money = more opportunities for profit. This is how option trading can be better than stock trading.
Should You Trade Options?
Now that we’ve listed all the ways you can make money trading options, how you can reduce or neutralize risk trading options, how you can sell options for a credit, and can trade the same size option position for less capital, the question is – should you trade options?
We think the answer is yes, and considering the options market is getting bigger over time, sometimes being larger than the share market for trading stocks, it means that the options market can and often is providing a larger portion of the order flow in the market.
The more order flow the options bring, the more influence they have on the price action. Hence, you could be trading the stock market now, and not even know how the option flows are moving the stock price up and down each and every day.
Hence, this is a major reason why we think you should trade options.
On top of this, when you see stock flows coming in, you have no idea if they are increasing the size of the positions at a particular price or not.
But with options, we can see each day whether the option flows are increasing at a particular price or not. This tells us whether the key support and resistance levels are getting stronger or weaker over time, and where the option traders are positioning their trades.
This gives us vastly more information to find out where the big players are trading, and how we can trade with them.
This is a significant advantage over trading stocks, thus another key reason why we think you should trade options.
Hence, in summary, when you look at all the ways options give you more ways to make money, better leverage than stocks, ways to sell options and get a credit, help reduce or neutralize your risk, and show you more information where the larger players are trading, we think it’s a no brainer that you should be trading options.
It’s important to understand trading options has its risks, and you’ll need to learn them, which is the focus of another article, but when you start to learn how the option market works, its hard to ever see the stock market the same, let alone want to trade in such a binary and limited way to make money in the markets.
I hope you enjoyed this article on how options can be safer than trading stocks and have peaked your interest into trading options.