Many options traders first cut their investing teeth with stock trading. In some cases, these investors have enjoyed a lot of success with stocks but want to branch out. In other cases, they have been trying to make a living off of day trading with stocks but it isn’t working out. No matter the motive, options trading is a great choice for many investors.
By trading options you can use new strategies to produce profits with different methods and during different market conditions. For example, with an iron condor you can make money off of horizontal price movements.
Options trading opens up a whole new world of potential. That probably sounds a bit high-minded but it’s true. Options can be used with a wide range of investment strategies. Many stock investors start buying options as a form of insurance for stocks they own. Other investors use options to gain alpha. In other words they want to produce a bit of extra profit.
Still, many investors turn to options trading after they find that day trading isn’t working out. It’s difficult to make a living off of day trading unless you are willing to expose yourself to a considerable amount of risk. You’ll either have to invest huge sums of money, or you’ll have to invest in risky penny stocks.
Options can offer a higher potential to produce profit while also lowering your exposure to risks.
Why Options Trading Beats Out Day Trading & Penny Stocks
Many stock investors who move into options trading are coming from either day trading or penny stock trading. Day traders attempt to make money off of temporary inefficiencies in the market.
Penny traders try to make money off of trading in higher risk, low-cost stocks. Penny stocks sell for $5 or less per share. Often, these stocks are for struggling companies that are at risk of going bankrupt or are facing major legal cases, etc.
Day trading can involve a variety of different risks. Usually, day traders care more about volatility and price movements, rather than the fundamental underlying qualities of an asset. Many options trading strategies also focus on price movements rather than underlying fundamental values.
Probably-Based Options Trading
I tend to promote “probably-based options trading.” Basically, my primary method focuses around calculating the probability of profit, or POP as it’s sometimes called.
There are a lot of tools that you can use to determine the probability of profit (soon Options Cafe will help with this). There are also a variety of trading strategies, such as the Iron Condor, that you can use to increase the probability of producing a profit.
Probably-based trading can produce high returns, especially when compared to stocks. With probability-based options trading, you often sacrifice some profit potential in exchange for lowering risks and increasing the likelihood of producing a profit.
High-profit, low-risk investments are rare, and usually the result of aberrations in the market. However, probably-based options trading allows you to consistently produce considerable profits. Over time, these profits can add up to a tremendous amount.
Options Offer A Lot More Bang For the Buck
Stocks are expensive. Options allow you much better leverage. This means you can turn a small amount of money into a lot of money.
Let’s say you are very confident that Acme Computers is going to launch a revolutionary new virtual reality technology. The VR tech is scheduled to be unveiled at the beginning of next month. You believe that this technology is going to be a big hit. It could the next iPhone or iPod.
Problem is, Acme Inc. stocks are selling for $100 dollars a pop and you only have $1,000 dollars to invest. You know Acme stocks are going to climb. You believe they could even hit $120 in the days that follow the VR tech release.
Yet you can only buy ten shares. Even if stocks reach $120, you would make only $200 bucks in profit. While that return is substantial, you know there is a lot more money to be made.
One option is to buy options for Acme stock. Let’s say you buy Acme stock options due to expire on the third Friday of the same month that the VR tech will be unveiled. Let’s assume that options to buy Acme stock ($100 per stock) are selling for $5 per option. Numbers like this are commonly seen in options trading.
Instead of buying 10 stocks, you buy 200 options. Your prediction turns out to be correct. Acme unveils its VR tech, and stock prices climb to $120 dollars in the days that follow. Now you can exercise your option contract, gaining a $20 dollar profit for each contract. That adds up to $4,000 dollars! This is certainly a lot more than $200.
Using Options As Stock Insurance
Another common reason for stock traders to start trading options is to use as a form of insurance.
Let’s continue with the Acme Computers VR technology example. The unveiling has already been planned. This time, let’s assume that markets are very excited about the potential technology. As such, stock prices have been slowly gaining, and have reached $100.
You, on the other hand, are not so excited. Let’s assume that you are a virtual reality expert. You’ve been following the technology for years. So far, everything you’ve heard about Acme’s virtual reality technology suggests that it isn’t all that revolutionary.
You believe that markets may be over-pricing ACME stock at the moment. Once markets come to the same conclusion, they could swing dramatically. Let’s assume that you own 1,000 stocks, or $100,000 dollars worth of stocks.
This represents a big chunk of your retirement portfolio. You have a lot of confidence in Acme and love their fundamentals. However, you’re worried about the VR tech unveiling and a potential price correction. You don’t want to sell your Acme stocks, but you don’t want to be exposed to any risks either.
So what should you do? Again, options are the answer. You can buy put options, which will allow you to sell your options at a predetermined price. So, you buy 1,000 put options granting you the right to sell Acme stocks at $100 in three weeks time. Let’s assume you pay $3 dollars per option. Again, this number is theoretical but realistic.
So you pay $3,000 for the option, or right, to sell your 1,000 shares at $100 dollars. Your dire prediction comes true. Acme unveils its VR tech. It’s a dud. Questions over leadership start swirling. Stock prices plummet.
Suddenly Acme shares are trading for only $75! You’ve lost $25,000 out of your retirement portfolio! But wait, you have your options! You sell your Acme shares for $100 instead. Instead of losing $25,000 like many other traders, you’ve lost only $3,000.
Other Reasons Stock Traders Love Options
Let’s go over some other reasons stock investors trade options. Turns out that there are plenty of reasons. For example, with stocks you make money off of price movements. If you buy stocks, you want prices to go up. If you short-sell, you want prices to go down.
With options, you can set up an iron condor for example. If you do, you want prices to remain stable, or within the trading range set up in your iron condor. If this happens, you will make money! There are only a few ways to generate substantial returns off of flat markets. An iron condor is one such way.
Speaking of short-selling, put options offer another way to make money off of dropping prices. Except, put options are far less risky than short selling. When you short sell a stock, you expose yourself to unlimited risk. No matter how high stock prices rise, you will have to buy those stocks.
With a put option you automatically know how much you can lose. When you buy put options the maximum loss will correspond with how much you paid for the options. In fact, the upfront risks of buying options are one of the chief reasons many stock investors start investing in options.
Further, there are now a ton of tools that you can use to analyze potential options trades. The nature of options means you can often plot out risks and scenarios with these tools. When you use these tools properly, you can greatly increase your probability of producing a profit.
Let’s Conclude With a Brief Stock to Options Trader Story
As you can see, there are many reasons why stock traders should consider trading options. This article is far from exhaustive. I’ve met so many stock traders over the years who started trading options and fell in love. Many have their own unique story.
In fact, I’d like to end with the story of a friend of mine. He’s quite well off, to be frank. I had been urging him to try options trading for quite some time. He recognized the advantages, but also didn’t want to leave his comfort zone.
With his investing returns stalling out, however, he decided to give options a go. He started with a small amount. I provided quite a bit of tutoring. Options made up only a small portion of his overall investment portfolio. However, he quickly found that he was making more money off options than his much larger stock portfolio.
He’s still trading options to this day. I’ll be honest, I get at least some of the credit for his success. I won’t say that I taught him “everything” he knows about options, but I taught him a lot. Fortunately, you can keep reading our blog here at Options Cafe and I’ll fill you in!
