If you’re new to investing, you’ve probably heard about options.
While buying and selling stocks is a simple concept to grasp, the idea of options can be quite confusing for some.
They can be risky! quote the naysayers. You can lose your money if you don’t know what you’re doing.
Yet, there are so many good reasons to trade options. With the right amount of training and exercise, using options to your advantage can lead to phenomenal wealth.
The benchmark for success is the S&P 500, which has averaged a return of about 10% over the last one hundred years. As you’ll see from my notes below, achieving a return of 40-50% with options is quite easily possible.
Here are 5 solid reasons you should trade options over stocks.
1. The cost to purchase options is much lower.
This means that less money in your portfolio is tied up in stocks. Here’s an example.
At the time of writing, Coca-Cola (KO) is trading at $40.65 per share. If you wanted to buy 100 shares, you would have to invest almost $4,000 of your money.
At the same time, the cost for the $40 call is $1.05. 1 contract = 100 shares, so if I buy the 40 call I would only have to pay $105.
Would you rather have $4,000 tied up in a stock, or $105?
What happens if the stock price goes up? Couldn’t I be making more money if I actually owned the stock?
2. The potential reward is significantly higher.
There’s a very important term to understand when it comes to trading options, and that term is delta. Delta is how much an option’s premium increases for every dollar a stock price increases.
In my above example, I used Coca-Cola. The current delta for the $40 call is $0.64. For every $1 the stock price rises, the option rises by $0.64.
Let’s compare numbers here.
Cost to get in: $4,065
Price if stock goes up $1: $41.65
Profit: $100, or 2.5%
Cost to get in: $105
Price if stock goes up $1: $1.70
Profit: $65, or 38.2%
With options, you don’t have to exercise the option to make money. You can turn and sell the option you’ve bought for a profit. In fact, this is how most options traders make their money.
I’ve tied up much less of my money, and made a much larger profit percentage wise. I’d say that’s a pretty good investment. The potential downside was only losing $105.
3. Options allow you to limit your risk.
This depends on the strategy you use. Combination spreads such as iron condors and vertical spreads allow you to limit your risk, while strangles and straddles could have infinite risk.
The bottom line is you have more control over your risk. I know many traders that follow a simple rule with trade setups, which is to never risk more than 2% of their portfolio on any given trade.
By defining the risk of a trade before you get in, you can set this 2% limit before you buy. This is an amazing benefit if you know how to setup the trade.
4. You can make money with stagnant stock prices.
As I mentioned previously, you can make a lot of money with stagnant stocks using iron condors. The idea that a stock price has to go up or down for you to make money is just plain wrong.
When you sell iron condors, you take in a premium from the buyer. If the stock price doesn’t move, and the contract expires, the premium is yours to keep.
Using the analysis tools offered to you by your broker, you can examine iron condor setups with a high probability of profit. Many investors use this method for producing income as it is predictable and highly likely they will succeed.
5. More strategic alternatives makes options more fun.
This is the part about options that fascinates me the most. Mostly because I’m a nerd and I love to analyze. You have so many strategies for trading, and investigating what your best move is going to be makes it a lot of fun.
You not only have multiple options combinations to analyze, but multiple expiration dates and mutiple strike prices. You can simply trade based on a stock’s volatility, examining multiple break-even points, probabilities of profit, and risk/reward analysis.