Get the exact step-by-step formula we use for our high-probability strategies to generate consistent income
In this article, we’ll discuss the benefits of trading options over stocks. Most people are familiar with stocks as the traditional investment vehicle. Because of their simplicity, stocks are where the majority of self-directed investors focus their time and energy. However, once you break the learning curve, options trading offers a few key benefits over traditional stock trading. Let’s take a look:
When you trade stocks, you are making a 50/50 bet on what the price will do. This is unpredictable at best. With options trading, however, you can make money if the stock goes up, down, or sideways. This gives you a lot more room for strategy. For example, you can create options positions that say “The stock price won’t go below X” or “The stock price will stay between X and Y.”
For example, the majority of the trades that we create are neutral strategies, meaning we expect the stock price to stay within a predefined range. With this type of strategy, the stock price actually has to beat you for you to lose any money, instead of the other way around. This is a much higher probability proposition than just betting on whether the stock will go up or down.
Stock price direction is only one way to make money as an options trader. When taking a look at the main factors that affect the price of the option contract, time and volatility play a crucial role. Options contracts are unique in that the value of the contract decays over time. This means that the time is on your side if you are an option seller. As options sellers, it is proven that factors like time and volatility work in our favor.
Options trading lends itself to many choices in picking strategies, defending losing positions, and a higher probability of success based on implied volatility. Stock trading, however, is either an up or down, black or white type of bet. You cannot be consistently profitable in this business trying to pick stock direction. With stock trading, you are hoping to hit a home run with every swing. Instead, by trading high probability options strategies, you can be profitable by consistently hitting singles (a much easier proposition). That is how you win the game.
90% of options traders use options in a way that leads to greater risk and inconsistency in profits. However, our trading strategies actually allow us to reduce risk and achieve consistent profits due to the high-probability nature of the strategies we use.
In fact, with the way we use options contracts, we have less risk than just trading stock. Let’s say you buy 100 shares of a $50 stock. This is a $5,000 investment, and that number is your full (though unlikely) potential risk if the stock drops to zero. On the other hand, let’s say you sell a $47 strike put options for $1.00 in premium. When you sell a put, you are taking on the obligation to buy 100 shares of stock at the strike price, or $47 in our example. In addition, you collected $1.00 in premium, making the effective purchase price $46 per share. There are 100 shares of stock in one option contract, so the full investment value is $4,600. This is 8% less risk than buying the stock outright.
Options contract have leverage. Leverage simply means that you are able to control more value relative to the amount you have to set aside to initiate the position. One common example of leverage is when you purchase a new home with a bank loan. You typically would put 20% down on the house and then borrow the remainder from the bank. In this case, you would be leveraged because you are in control of the full value of the house, while only putting down 20% of the value upfront.
This is the same case with options contracts. With options, you are able to control 100 shares of stock at a fraction of the actual value of the 100 shares. Let’s say XYZ stock is $50 per share. 100 shares of XYZ stock at $50 per share is a total of $5,000. If you were to trade the stock, you would need 50% of the value, or $2,500 (stock trading gives you 2 to 1 leverage). On the other hand, if you were to trade the options, you would need roughly 20%, or $1,000 (5 to 1 leverage). In some cases, the leverage can be greater.
Leverage is a double-edge sword. It can magnify your gains and losses. If you produce the same dollar profit between trading stock and trading options, but put down less money for options trading, your return on capital is increased. However, the same is true for losses.
With the options strategies that we trade, leverage works in our favor by magnifying our gains. Though losses can occur, there are strategies and techniques used to defend losing positions, mitigating the impact of the losses.
Options trading has a few key advantages over traditional stock trading – options are strategic, options can have less risk, and options have leverage. Options trading is an intellectual challenge which provides opportunities to make strategic decisions on what to trade, when to trade, and how to trade. Learning the fundamentals of why we do what we do is important to your growth as a trader.
If this explanation of options trading is better than stock trading, let us know in the comment section below!
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