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Investing in the stock market is a fulfilling activity of choice for do-it-yourself investors. Taking control of your finances, whether that be as a second stream of income or preparing for the future, smart investing can be extremely beneficial if done properly. In addition, many investors love the thrill associated with buying and selling the markets along with the satisfaction and sense of pride that goes along with managing their own money and taking control of their own financial well-being.
Most investors are familiar with things like stocks, bonds, and gold. However, those who wish to ramp up there investing to the next level should consider options. For those investors who have already had success at these more familiar products, they might be wondering why they should consider a more complex investing vehicle like options. The truth of the matter is, options offer several advantages over other investment products, and if used correctly, should add a significant boost to any investor’s return over the long run.
The Advantages of Learning How to Trade Options
When an investor combines options with stock, it not only allows them to diversify their portfolio, it will enable them to make additional income off the stock they already own. This is an excellent strategy for both rookie and expert traders. For example, if an investor owns the stock XYZ, which is currently trading $50, the investor could sell a 55–strike price call for $2 going two months out.
If the stock fell to $47 over the following two months, the investor would lose $3 on the stock. However, because they sold the call option for $2, their net loss would only be $1. By selling the call option, the investor changed a 6% loss into only a 2% loss.
Another example would be if the stock traded up to $54, here both the stock trader and the options trader would have a $4 profit on the stock, but the options trader would also have an additional $2 of profit, for a total profit of $6. Here, the options trader had a 50% higher return verses the trader that just traded the stock. An investor that added this type of income month after month would have a substantially higher return on capital over the year.
Finally, let’s assume the stock traded up to $58. Here the stock trader would have an $8 profit from the movement in the stock, while the options trader would have the stock called away from them at $55, giving them a $5 gain in the stock. But because the options trader sold the call option for $2, they would have a net profit of $7. Although the stock trader did indeed outperform when the stock had a substantial move to the upside, this is the only scenario where the stock trader would be better off, and they were just barely better off. In all other scenarios, and the more likely scenarios, the options trader would have the advantage.
Cost of Entry
Buying stock can be extremely expensive, for an investor looking to control 100 shares of a stock trading $50, they would have to fork out $5000. Not necessarily something that all investors can do. In contrast, an investor can buy one at-the-money call option, which controls 100 shares, for a price of about $300. As you can see, by investing with options, an investor can dramatically lower the cost of entry. In addition, the options trader can only lose the $300 they bought in with. If the stock were to drop to $40, the options trader would lose their $300 investment, but an investor who took the stock position would lose $1000.
Make More Using Less Capital
Because option traders have a lower entry cost, there is a greater potential for above-average gains on the investment. Instead of buying 100 shares of XYZ stock for $5000, an investor could potentially buy one option contract in 16 different companies, controlling a total of 1600 shares, and still have money left in the bank. If they’re correct on their analysis, they could gain an impressive return on capital.
Most stock traders seek out quality companies and go long, meaning they buy the shares in expectations of a bullish move. More advanced stock traders are confident enough to sell a stock short, expecting a bearish move, but shorting a stock does come with unlimited risk. Options traders, on the other hand, have a wide range of options strategies at their fingertips. Calls and puts may be used on their own or combined in one of several different ways for an endless amount of option strategies. Whether a trader expects bullish, bearish, sideways movement, or just wants to capitalize on a change in volatility, there is an option trade for every type of market environment.
For traders who learn how to use options strategies properly, they can push their annual returns higher, make more money using less capital, diversify an already existing stock portfolio, set their own probability of success, and define their level of risk. For investors who want to learn options trading and make that jump to the next level, make sure to put in the time and effort it takes to make that jump to the next level.