The stock market can be intimidating, especially for rookies. From knowing which investments to make and how much to invest, the rules of the trading game are complex. While it may be more comfortable to watch from the sidelines with your money tucked safely in your back pocket, playing the stock market doesn’t have to be as risky or expensive as most think, especially when it comes to trading options. This week, we’ll discuss why you should trade options instead of stocks to score the best bang for your buck.
What is an Option?
First, let’s define what an option is: An option is a contract that gives a person the right to buy (calls) or sell (puts) shares of an underlying stock at a predetermined strike price and expiration date. Although an option grants you the right to buy or sell shares of an underlying stock, it does not obligate you to do so. Each contract typically involves 100 shares of an underlying stock.
Call options are “in the money” when the price of the underlying stock rises above the predetermined strike price, whereas, put options are “in the money” when the underlying stock price falls below the strike price.
The buyer of an in-the-money call has the right to purchase the underlying shares at the strike price — which would represent a discount to what they’d cost on the Street — before the expiration date. Meanwhile, the buyer of an in-the-money put has the right to sell the underlying stock at the strike price, fetching more than what they’d get outright. These traders could also choose to not exercise their contracts, and instead sell to close their options at a profit.
So why try your hand at trading options instead of stocks? It’s simple:
Options Are Cheaper
Purchasing an option can be dramatically cheaper than buying shares of a stock outright. Say stock XYZ is trading at $100 per share. It would cost you $10,000 to buy 100 shares. Instead, if you purchased a call option at a market price of $25, it would only cost you $2,500 to gain control over 100 shares of stock XYZ. A lower entry price leaves more money in your pocket for future investments.
Options Limit Losses and Provide Leverage
A lower entry price also means less money is at stake. An option buyer’s losses are limited to the price of the option, since the trader is not obligated to act on the option before its expiration date. Meanwhile, gains on a long call are theoretically unlimited to the upside, offering lots of leverage. Likewise, long puts increase in value the further the underlying stock falls to zero. A trader’s potential percentage return is dramatically higher during an option purchase versus a stock purchase, since it’s easier to double a $2,500 investment than a $10,000 one.
Options Let You Choose
While stocks pigeonhole a trader into long and short investments, options provide a range of strategic investment alternatives. Through options, traders can buy calls to simulate stock ownership, buy puts to simulate a short sale, or combine calls and puts to profit from upward, downward, and horizontal stock movement. Options let you choose how and when to profit from your investment, so why not choose options over stocks?
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