Stock Options Vs Stocks
I often relate the investor education space with the health and fitness business.
There are so many gimmicks and fads… preying on those uniformed poor souls who are just trying to improve their lives. The one thing that really ticks me off… is when I read articles or watch the talking heads say that options are a suckers game.
Sure, option investing is not for everyone… however, if you’re investing in stocks… and you’re not using equity options to express your market sentiment… you’re doing something wrong. The chances of a stock moving higher or lower is 50/50.
However, with options you can structure trades that skew the probability more in your favor.
In most cases, using options instead of buying outright stocks is a better deal… not to mention, the ability to shift the odds in your court.
First, options are leveraged instruments.
That means you need less capital to get started. For example, one equity option contract leverages you 100 shares of stock. Let’s say AMNZ is trading at $337.49 per share (hyphotetical situation).
For $33,749 you could buy 100 share of stock (not including commissions and fees). On the flip side, you could buy one call option… controlling the same amount of shares for a whole let less.
Let’s say you had a bullish bias and bought a SEP $320 call option for $2900 (expiring in 76 days). In very simplistic terms, this SEP $320 call will gain $67 for every dollar move higher in the stock price.
If you owned the 100 shares instead… your PnL would be $100 higher for every dollar higher the stock price moved.
However, look how much more capital is needed to purchase the stock… more than 11x the amount of money.
In fact, if the stock investor bought 10 shares for $3374.90… they would only make $10 for every dollar the stock price moved higher… advantage options.
Options give you a chance to diversify your stock portfolio.
In the above example, an investor would have to shell out nearly $34,000 for 100 shares of AMNZ.
If they had a small trading account… it would be very difficult for them to diversify because of the huge capital suck the stock purchase costs.
An investor with a $25,000 portfolio can do A LOT more with options in terms of diversification and profit potential (from the leverage). Using stocks instead of options is a poor use of capital… and it hurts the small investor who wants to have a balanced and diversified portfolio.
Furthermore, buying options and structured option trades both define and limit risk.
For example, when you buy a stock… your risk is limited to your initial investment. In this case, the risk is $33,749.
Of course, the likelihood of AMNZ going to zero is highly unlikely.
However, if you’ve lived through the dot com bubble and the most recent financial crisis… you’ll know that anything is possible. With the SEP $320 call option… the total risk on the trade is $2900.
Not only that, but the long call option enjoys the same benefits as the long stock position, that is, undefined profit potential.
A more realistic fear than AMNZ going to zero is a mini-flash crash. Program and High Frequency Trading play a significant role in the U.S. Stock Market. One only has to look at the funky events in Anadarko Petroleum Corporation (APC) last year to see how powerful they are.
“On May 17, 2013, in the final seconds of trading, the stock of Anadarko Petroleum Corporation (symbol APC, market cap $45 Billion) traded from $90 down to $0.01 in 45 milliseconds. Oops. This may just be a record – losing $1 Billion per millisecond. That’s a rate of $1 Trillion per second. Now this is something Congress will be able to understand. Maybe NYSE should have kept their LRP circuit breakers after all?”
Now, if you’re a long term investor, there is a good chance none of this will really influence the way you invest. However, it might if you’re a responsible trader… who has stops in place to limit losses.
How upset would you be if there is a mini-flash crash in the stock you’re in… and you get stopped out… only to see the stock rebound back? This is a very real concern.
Of course, in the case of APC… a lot of those bad price prints were busted… but I’ve heard horror stories of traders who have lost real money from these mini-flash crashes. It’s a lot more soothing… being in an option position… where you’ve got defined and limited risk.
But Aren’t Options Too Complicated…
With options you can express your market opinion in so many different ways.
For example, there is a strategy when you think a stock will stay flat… not only that, but you can be very precise… especially on the magnitude of the stock price move: a little higher to a lot higher, a little lower to a lot lower.
As you get more advanced and comfortable with options… there are strategies that express a range bound move… and even non-directional strategies that focus on your views on volatility.
Heck… there are times where I’ve made a profit on a position even though I was totally wrong on my assumption.
I would have lost money if I owned the underlying, but because I used options and structured trades that provided an opportunity to make money even if I was wrong.
Options Give You the Flexibility to Be Positioned For All Market Conditions
Stocks can go up, down or trade sideways. However, if you buy a stock, you can only make money if the share price rises. On the flip side, if you’re short stock, you can only make money if the share price drops. If the stock trades sideways… you don’t make money.
With options, you can take advantage of those situations as well.
The possibilities are really endless. But the key is not to be scared about option investing. Sure, if you’re reckless and irresponsible… you can lose money fast.
That should go without saying… but if you learn the right approach… and build a foundation… option investing will trump stock investing most of the time.
Let’s face it, the people discouraging you from options are the ones who don’t fully understand them. And believe me, if you don’t have the time or patience to understand options… you probably should stay away.
Stock investing is like driving a Ford Pinto… it will get you from point A to B… and you won’t have a problem handing it off to your 16-year old when they’re practicing for their drivers test.
Option Investing is like a Ferrari GTE Spider… a powerful, sophisticated machine with several gears… something you wouldn’t dare let your 16-year old take for a spin around the block.
Are you a stock investor looking to take the plunge into options?
If so, I’d love to hear your reservations on why you haven’t taken the plunge.
Also, if you’re new to options, I’d like to know how it’s going so far… what’s been your biggest obstacle so far?