Short Term Investing – Why Stock Options Are Better Than Stocks

by Bullhunter on June 1, 2010

Stock Options vs StocksMany investors believe that stock market investing has to be a 50-50, symmetrical profit- loss potential, game. So that if the stock goes up $100, they will make $100 per share, and if it goes down $100 they will lose $100 per share.

In principle it sounds fair and logical, but is it really? Most of the time investors commit huge amounts of capital buying the very top in the markets, the risk is enormous.

Then there’s the products of stock futures and margin trading, these seem great, require much less capital, but when you buy stocks, the broker charges you interest on the leverage money used. Also the broker forces you to use stop loss orders, which quite often work against you by getting you out of the market unnecessarily.

So do stop loss orders really offer you limited loss and unlimited profit potential? To the majority of investors and traders, definitely not! Only the very experienced can trade futures well.

Short Term Investing - Why Stock Options Are Better Than Stocks

As you can see on the above Apple (NASDAQ:AAPL) stock chart, a huge down spike would have knocked out any long futures contract or even a long stock position held on margin. A Call option on the other hand would have remained intact.

Stock Options vs Stocks

Also stock options offer this asymmetrical profit – loss relationship, for example on the last down day on the above (AAPL) chart, the stock dropped by a whole $10. Its deep In-The-Money Call options only dropped by $3.9. If the stock rose $10, these Call options would rise by $8.

In other words, with these stock options at that price level, you lose $390 when the stock drops $10. But when the stock rises $10, you win $800. That’s where the asymmetry is. It is something the actual stock investor doesn’t have, of course options still cost a lot of money and only last few months, but sometimes they are much better than actual stocks or futures. 100 shares of (AAPL) here would cost $24,200 whereas a single Call option would cost around $2,800.

Generally options trading is complicated and does have many tricks that may work in your favour, or against you. Such as the bid-ask spread that widens a lot during days of high volatility and during expiration weeks. This alone, if not handled properly may cost you $100′s on expensive options as the one described above.

Other than that, you have nothing else to worry about while trading deep In-The-Money stock options, other effects such as time decay is so small, that it is of no concern.

Guest Post by..
Scott Smith @ investingthestockmarket.com

The Bullhunters Guide
Universal Wealth Creation © 2004 – 2010

{ 9 comments… read them below or add one }

Jayne Pleysier July 16, 2010 at 3:50 am

You are right…options trading is complicated and there is a lot of maths behind the scenese in working out the options pricings based on the Black-Scholes model. I have recently started studying Option Trading for US stocks and the potential of what options can do for risk to reward is fantastic if you can choose and manage your calls and puts well!

With the US market currently experiencing such high volatility learning the strategies to employ is extremely important.

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Cathy Howitt July 20, 2010 at 2:37 pm

Jane, you are a lady of many talents. I honestly don’t know when you get the time to do all of this, but I take my hat off to you. Good luck with your option Trading.
Cath

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Peter Damien Ryan July 21, 2010 at 12:52 pm

Given that volatility, learning the strategies is more than important – it is crucial and essential.
Your mention of maths makes me think that it is an area where I shouldn’t walk alone! That type of needed analysis is beyond me – yet I can see from the article how it is necessary.

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Cathy Howitt July 20, 2010 at 2:42 pm

You too, Sean, are a man with many talents. This is a great blog on short term investing and why stick options are better than stocks. I must get my husband to read this as he is right into all of this at the moment too.

I also like the idea of a guest blogger. Whilst I have no doubt Sean, that you know all about Options trading, it is such a great idea to get someone other than yourself who has a passion for this trading to share his ideas and wealth of information.

Well done.
Cath

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Jody Chambers July 20, 2010 at 10:21 pm

I have never traded options but have been to several seminars on them through 21st Century Academy..they make perfect sense to use as you can control more stock without forking out all the capital. And as Bullhunter pointed out expose yourself to more upside and minimise your downside…or even ‘insure’ your downside with a put.

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Elly July 21, 2010 at 10:49 pm

Hi Jody

It is really good to insure your options with a put but then again one must be careful. Sometimes stocks can move in a wider range and you don’t always know when this is going to happen.

Putting a put option too close to the underside of your covered call for instance can cause you to have your stock exercised if the stock price falls down past your put (insurance) then you have lost money. and the stock.

There is a lot to weigh up in trading and no end to having an intense education which you will have when you go live. It can be very rewarding if you learn well.

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clem schollum July 22, 2010 at 9:16 pm

thanks for such a great clear picture of option trades and deep in the money trades are all we ever did and it seemed to work out fine. We did buying options to make faster cash with less output until we got “stuck with” some shares, not that that was a bad thing because then we sold the options. Pretty good money earner for a while but I would love to hear Sean’s thoughts on the options market in globally unstable markets- still good cash cow?

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Jazz Salinger July 30, 2010 at 8:57 pm

Hi Scott,

So, this definitely looks complicated to me but it’s just because I don’t fully understand what you’re talking about. I have so much to learn about investing in stock options and stocks.

But, I like the chart and I’m pretty sure I could learn to read one and see the same things you see. I just have a lot more learning to do before I get to that point.

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Kerrie Setiawan July 22, 2011 at 8:08 pm

With the right stock market education, options is the way to go…

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