1 – Leverage
As an options buyer, for a fraction of the cost, you can control at least 100 shares of a stock on the American stock market. For example let’s say XYZ stock is currently trading at $545 per share. To buy 100 shares of XYZ stock, you would need to fork over $54,500 ($545 x 100) plus commission. To buy 1 call contract [two months before expiration] at the $550 strike price, it might cost you a premium of $27.4 per share or $2,740. To purchase the $550 call contract one month out would cost you $19.2 per share or $1920. This my friend, is the power of leverage.
2 – Profit in terms of percentage 600% verse 3% on the same stock
Using the example above, let’s say you purchased 1 XYZ call contract with the strike price of $550. If XYZ stock had an upward price movement of $20 (which is very common for a volatile stock like Google) your call option would increase in value by at least $20 per share or $2000. If you had purchased the closer $550 call option, your profit would be 102%. If you purchased the two month call option your profit would be around 79%. Now, if you had bought XYZ stock outright your profit would have been 3.6%. So, in terms of big percentage profits, stocks vs options, options are more profitable.
Let’s try applying the same strategy to a less volatile stock such as stock ABC which is trading at $27. The two month call option on ABC would cost around $0.4 per share or $40 per contract. Using $400 you could control as many as 1000 shares of stock ABC. If ABC stock moved up by as little as $2, your position (10 call contracts) would be worth $2,400 for a profit of 600%. If you had bought ABC stock you would have made $2,000 on an investment of $27,000, which is the current price of ABC x 1000 shares of stock. Buying the stock would have given you a profit of around 7%. So once again, in the game of stocks vs options, options are more profitable.
Note: XYZ options would be more expensive than ABC stock, because XYZ stock is very volatile and could easily swing as much as $15 in a matter of minutes.Volatile stocks are good for options buyers.
3 – Losses will not be as great if you are an options buyer
To keep things simple, let’s expand on the same position and concepts from above. Let’s say you had bought 100 shares of XYZ stock ($54,500) or 1000 shares of ABC stock ($27,000) instead of buying the call options at $2,740 and $400 respectively. If XYZ and ABC stock prices both drop to $0 per share, you will have lost $54,500 and $27,000 respectively… a whole lot of money!!! If you had purchased the call option, your losses would have ONLY been $2,740 and $400 respectively. So with options you are looking at HUGE profits and SMALL losses.
4 – Rules that apply to stocks don’t apply to options – example short selling
Short selling basically means you borrow money from your broker and sell a stock at some high price and hope to buy it back at a lower price later. To prevent people from artificially driving stock prices down via short selling, there are certain rules in place. One rule says that you cannot short-sell a stock after a down day. So, if XYZ stock price closed down on Monday, you cannot short sell the stock on Tuesday. However, if XYZ closed up on Monday, then you can short-sell on Tuesday. This “down-day” rule, does not apply to options. If you missed out on the first down day on a stock and you think it has a long way to go, simply by some put options at any time and you can profit from any further moves downward on the stock. Also,by buying put options you are not using borrowed money, so you won’t need to worry about annoying calls from your broker.
5 – Easier to make money with options trading strategies
A stock price can move in three basic directions, UP, SIDEWAYS, or DOWN.
The typical stock strategy involves either going long on a stock or short selling the stock. By buying or shorting a stock you can only make money if the stock goes up if you bought it, or down if you did a short sale on the stock. With the right options strategy you can make money if the stock goes up, sideways, or down. Yes, you read that correctly. With the RIGHT options strategy you can make money if the stock goes up, stays flat, or goes down. You can guarantee your profits in two of the three directions, while your chances of success in the third direction will be determined by your strike price. So, with stocks you profit in only one direction, while with options you can guarantee profits in two of the three directions and the third direction is determined by your option strike price.
6 – Options strategies can be more conservative that stock strategies
You can use options as insurance on stocks you already own to protect you from unexpected price moves. You can also use options strategies to get paid to buy stocks. This latter strategy of getting paid to buy a stock is referred to as Naked Put selling. By owning stocks without the use of options, you are very vulnerable to unexpected market events such as… a recession. If you don’t believe me, ask the former millionaires of the DOTCOM boom and the current recession that saw their 401k’s wiped out.
So, there you have it, 6 reasons why I think options are a better choice than stocks. If you have any questions or additional ideas, feel free to leave me a comment, thanks.