Updated: Sep 21, 2020
For novice investors, you will naturally gravitate towards investment in stocks. Many people have misconceptions regarding options trading, believing it to be complex and risky. However I personally find options trading to be complementary to stocks. Even if you believe in long term stock investments, you can enhance diversify your portfolio by including these powerful tools to make money out of the equity markets, minimize risk without missing out on gains. Options do provide powerful and unique advantages to your portfolio.
OPTIONS ARE LESS EXPENSIVE TO PURCHASE THAN STOCKS.
Options do not necessarily take as much capita as buying purchasing of stock. This is advantageous to investors with limited budget. Each option contract provides control of 100 shares of the equity, yet the cost (premium) to purchase an option contract is very low compared to the expense of buying an equivalent stock.
OPTIONS PROVIDE LEVERAGE AND POTENTIAL DOWNSIDE RISKS ARE CAPPED.
When you buy stock, your potential gains are theoretically unlimited, while your potential losses are limited to the full original investment (excluding brokerage fees incurred). When you buy call options, it is the same theory, the gains are potentially limitless, while your losses are capped at the initial premium paid, except it costs much less to purchase calls than to buy stock. The ROI is much higher.
OPTIONS ARE MORE FLEXIBLE THAN STOCKS.
When dealing with stock, you are limited to buying shares (a long position) or selling shares (a short position). With options, you can find a many strategies, e.g. options can be bought and sold in a variety of different combinations, allowing traders to fine-tune strategies to match with their market outlook, bullish, bearish, neutral, or otherwise. You can choose from a variety of expiration dates -- anywhere between a short expiry weekly option and LEAPS that will expire as distant as three years in the future. You can also pick a strike based on not only your expectations for the stock, but your tolerance for risk. There is also some predictability since you and the seller decide on the strike price. That makes it easier to gauge how much you stand to gain or lose by exercising an option.
OPTIONS AS HEDGE AGAINST MARKET VOLATILITY.
Stock investors can use options as a hedging mechanism. For e.g. protective puts can be bought to limit risk when acquiring stock and to protect a previously-purchased stock when the short-term forecast is bearish but the long-term forecast is bullish. If the stock price declines, the purchased put provides protection below the strike price. This strategy mitigates potential losses if the value of a stock you own goes down and the price you pay for the option is akin to an insurance premium.
OPTIONS PROVIDE OPPORTUNITY TO ACQUIRE DESIRED STOCK AT LOWER PRICE WHILE COLLECTING PREMIUMS.
Provide premium income while waiting to acquire desired stock instead of purchasing the stock directly, you can sell put option at lower strike price for a longer period of time (say 2 years to expiry). By selling this option, you are agreeing to buy 100 shares of this company at the lower price no later than two years from now. You will collect the premium while you wait. If the stock drops to lower than strike price two years from now, you will be required to buy the desired 100 shares at that price, but you will also keep the premium so your net cost to purchase will be lower. Alternatively, if shares do not fall to that price by that period, the option will expire worthless and you will keep the entire premium.
On the flip side, options trading can have a greater potential for loss than equity trading because you’re making a bet that a stock price will move one way or another. If your assumption about a stock’s price movement is incorrect or you transact at the wrong timing, you could lose money instead of turning a profit. That being said, investing in stocks is also not without risk, since the market can go through periods of volatility. A stock can potentially go down to zero, losing the entire investment.
One advantage stocks have is that since there is expiry date, there is no pressure to sell. While past history is no guarantee of future performance, you can look at the track record to decide whether to invest in it. With advantage of time on their side, it can be purchased at one price and sell it immediately, potentially earning some short-term capital gains, or, it can be held on for years, selling when the time is right for you, with added incentive to earn dividends during that time period.
So options trading can be riskier than stocks. But if done correctly, options trading has the potential to be more profitable than traditional stock investing. Selecting whether stocks or options is entirely a personal decision, based on one’s investing style. Novice investors who prefer simplicity will start with stocks trading. But experienced traders, favouring a more active investment approach would prefer options for the benefits mentioned.
In conclusion, there are great benefits in trading options. Even for die-hard stock investors, you do not have to stick to one asset. Options traders inherently become stock investors if they exercise call options and many stock traders use put options as a hedging mechanism. You can take advantage of both. But leaving out options trading in your portfolio entirely, in favour of stock trading, will be a missed opportunity.