Last updated on February 14th, 2022 , 09:41 am
So, you’ve read a couple of articles about options trading before, or maybe you have some friends that trade them, but you haven’t yet taken the plunge. What’s all the hype?
In this post, projectfinance is going to share our list of the top eight benefits of trading options.
TAKEAWAYS
- When compared to stock, options require less capital.
- Options are usually leveraged at a ratio of 100:1, meaning one contract represents 100 shares of stock.
- Options allow investors to profit from any market direction.
- Using metrics such as the “Greeks”, options trading lets investors choose their trade’s probability of success.
- Options trading allows investors to reduce their overall risk in various positions.
- You can combine stocks and options together in strategies such as the “covered call”.
- Unlike stock, options are generally short-term trades. This forces traders to be in sync with the undulations of the market.
#1: Lower Capital Requirement
Investing in shares of stock is expensive, especially for young investors who don’t have a lot to work with. For example, consider the capital requirement for the stock investments in the following table:
| Stock Price | Shares Purchased | Capital Required |
|---|---|---|
|
$100 |
50 |
$5,000 |
|
$250 |
75 |
$18,750 |
|
$500 |
100 |
$50,000 |
*Cash Account
As you can see, buying shares of stock requires significant sums of money, especially for young investors who are just getting started. Sure, you could buy a few shares here and there, but the stock prices will need to appreciate substantially to experience any decent returns, and buying a low number of shares is extremely inefficient in terms of commissions.
With options, you can implement strategies that require a few hundred dollars to enter. Here are two hypothetical option positions you could enter that don’t require significant sums of money to implement:
| Options Trade | Capital Required | Profit Potential | Max Loss |
|---|---|---|---|
|
Sell $2-Wide Iron Condor For $1.00 |
$100 |
$100 |
$100 |
|
Sell $3-Wide Put Spread for $1.00 |
$200 |
$100 |
$200 |
As you can see, some options strategies can be implemented with a very low capital requirement. However, it’s important to note that you should always consider the potential loss on your portfolio if a position turns out to be a loser.
#2: Options Give You The Ability to Use Leverage
The second reason investors should learn to trade options is that options give you the ability to use leverage. While leverage is a weapon of mass destruction for the unprepared and naïve, leverage can be powerful when implemented properly (and with a plan).
Let’s take a look at how options can provide leverage:
| Stock | Stock Price | 100 Share Cost | At-The-Money 1-Year Option Cost |
|---|---|---|---|
|
AAPL |
$117 |
$11,700 |
$1,200 |
|
TSLA |
$203 |
$20,300 |
$3,300 |
|
GOOGL |
$800 |
$80,000 |
$7,500 |
As we can see here, buying 100 shares of any of these stocks costs between $10,000 and $80,000. However, an investor could purchase an at-the-money call option and control 100 shares of each stock for a year at a fraction of the cost. In each case, using a call option to gain exposure to 100 shares of stock can be achieved at 10% of the cost of buying shares.
Let’s look at the return potential on the AAPL call option from the previous table based on various stock prices in one year:
| Stock Price in One Year | Return on 100 Shares (Bought at $117/Share) | Return on 115 Call (Purchased for $1,200) |
|---|---|---|
|
$50 |
-$6,700 (-57%) |
-$1,200 (-100%) |
|
$117 |
$0 (0%) |
-$1,000 (-83%) |
|
$135 |
+$1,800 (+15%) |
+$800 (+67%) |
As you can see, buying a call option instead of stock provides immense return potential when the stock price increases. Additionally, a call option has limited loss potential when the stock price decreases.
However, buying a call option will be unprofitable if the stock price doesn’t increase by a certain amount, and maybe you don’t want to implement a strategy that loses money when the stock price doesn’t change.
Let’s look at the profit and loss potential on a 60-days until expiration options strategy that requires $750 to implement. Again, we’ll use AAPL options for the example:
| Stock Price in 60 Days | Return on 100 Shares (Bought at $117/Share) | Return on 115/105 Put Spread (Sold for $250; $750 Maximum Loss) |
|---|---|---|
|
$100 |
-$1,700 (-15%) |
-$750 (-100%) |
|
$117 |
$0 (0%) |
+250 (+33%) |
|
$125 |
+800 (+7%) |
+$250 (+33%) |
|
$130 |
+$1,300 (+11%) |
+$250 (+33%) |
With this particular options strategy, a return of 33% can be achieved in 60 days without any change in the stock price. Additionally, when the stock price collapses, the losses are less significant than owning 100 shares of stock. What’s the catch? Well, the profit potential of the options strategy is limited, whereas owning shares of stock has unlimited profit potential.
In summary, options give investors the ability to implement strategies with a low cost of entry. Additionally, strategies can be customized to profit from certain scenarios, which brings us to the next reason every investor should learn options trading.
#3: Customize Your Strategy
As you saw in the previous examples, options provide investors with ways to customize strategies based on their investment theories regarding a particular stock. Here are a few ways options trading can be custom tailored:
- Have a trade time frame as short-term as a few hours or as long-term as two years.
- Profit when the stock price increases, remains in a specified range, decreases, or even moves against your position slightly.
- Profit primarily from the passing of time, or changes in the level of fear in the marketplace.
- Generate income each month on shares of stock you own while waiting to sell those shares at a higher price (with the covered call strategy).
- Generate a stream of income each month while waiting to buy shares of stock at a lower price (with the put-selling strategy).
As an example, check out the performance of this strangle options strategy that profits as long as the stock price remains in a specified range:
The chart above illustrates just one example of how options can be used to customize your strategy. Aside from customizing your specific strategy, options allow you to choose the estimated probability of making money on a particular trade.
#4: You Can Choose Your Probabilities
When purchasing shares of stock, the share price must increase for you to make any money. On a short-term basis, the probability of a stock rising or falling from its current price is estimated at 50%. This means the probability of making money from buying or shorting stock is approximately 50%.
With options, the estimated probability of making money can be below or above 50%. More specifically, options traders can choose the estimated probability of making money on a trade based on the risk and reward relationship of their proposed strategy.
For example, traders who primarily sell options typically have more loss potential than reward potential, and therefore have a probability of profit that’s greater than 50%. On the other hand, traders who buy options typically have more profit potential than loss potential, and therefore have a probability of profit that’s lower than 50%.
So, if you’re a trader who prefers to have limited risk and high reward potential, your strategy will have a low probability of profit. On the other hand, if you’re ok with having more loss potential than reward, your strategy will have a high probability of profit. Either way, you can choose which side of the equation you want to be on, and even balance high probability trades with some low probability trades.
#5: Options Can Be Used to Reduce Risk
When most people hear about options, they typically hear about how incredibly risky they are. Frankly, these comments are warranted, as many individuals abuse options and implement them with highly risky approaches that are doomed to fail eventually.
However, options can be (and often are) used to reduce the risk of an existing stock or option position. Let’s look at an example of how options can be used to eliminate the loss potential of a long stock position below a certain price:
As we can see here, a put option is used to reduce the losses of a stock position below a certain price. Without the put option, the loss is $5,000 at the worst point. However, the stock position that is protected by a put option only experiences a loss of $2,368 at the worst point.
Here’s an example of how call options can be used to reduce the risk of a long stock position:
In this example, it’s clear that the covered call position (selling a call against 100 shares of stock) performed better than the stock position the entire time. More importantly, the losses on the covered call position were always less than the losses on the stock position by itself.
The last two examples demonstrate how simple implementations of options can reduce the risk of existing positions.
#6: You Can Combine Options With Stock Investing
Reason #6 for why investors should learn to trade options is that you don’t have to choose options trading or stock investing. You can do both!
Options are a perfect complement to stock investments. After all, options are derivatives of stocks, which just means their prices are derived from the stock that they’re traded against.
As a stock investor who understands options, you will:
- Know how to use options to create a stream of monthly income on the shares you already own.
- Understand how to reduce the risk of, or lock in profits of a profitable stock position.
- Be able to calculate the estimated probabilities of specific stock price changes over any period of time.
- Have the ability to gauge how the market perceives the riskiness of a particular stock by looking at the stock’s option prices.
There are many benefits of knowing options as a stock investor. Always remember that you don’t have to abandon buy-and-hold stock investing for options trading, you can do both. Why limit yourself?
#7: You'll Be More In Tune With the Economy
As a stock investor, it’s much easier to buy some shares and forget about the market for months at a time because stock investments are typically long-term.
As an options trader, there’s a good chance most of your trades will be short-term in nature (typically less than 60-90 days). As a result, you’ll be actively placing, adjusting, and closing trades. With more exposure to the markets through your positions, you’ll be more in tune with events related to the stocks that you’re trading options on, as well as macroeconomic events
With more exposure to the markets, there’s a higher probability that you stumble upon other attractive trading or investing opportunities.
#8: Trading Options is FUN
Investing in the markets is exciting in general, but there’s nothing quite like the freedom or flexibility that comes with the ways you can apply options trading to your portfolio. It doesn’t matter whether you trade options for risk reduction, aggressive speculation, or steady monthly income, trading options is fun, plain and simple. Everybody likes a little fun, right?
Final Word
As opposed to stock trading, options offer investors both leverage and flexibility. However, these benefits do indeed come with added risks.
Options trading requires diligence. The set-it-and-forget-it approach does not work here. If you’d like to jump-start your education on learning about calls and puts, please check out our comprehensive article below, Options Trading for Beginners.
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