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Why Stock Is More Risky Than Options!
We prefer to trade in options rather than stock.
We prefer to trade in options rather than stock.
But you have probably been told or read that options are risky. Even worse, that you can lose your shirt trading them!
How do you know which is the truth?
I want to take a few minutes and look at stock ownership. What are the possibilities when you buy stock?
Stock can go up in value
The stock price goes down.
The stock prices moves sideways.
Clearly if the price goes up you make money. Just as clear, with the second scenario you lose money.
However if there is sideways movement you will not directly gain or lose money. You will however incur costs through brokerage fees directly and indirectly lose money through what is know as “opportunity cost.”
This is the cost due to lost opportunities. The fact that you aren’t able to be involved in other, potentially profitable trades.
In conclusion the only way you can profit when owning stock is when its value goes up.
OK, the next possibility is short selling stock.
Shorting is a method to consider but it comes with a high risk which leads us not to recommend this option.
You see, when you short a stock, you actually sell a stock that you don’t own. And your intention is to then buy the stock back at a lower price. The price difference is your profit per share.
Do you see what the risk is?
Well what happens if the stock price goes up? Particularly if it goes up a lot?
Having traded the stock at a lower value when you have to buy it back it costs you more resulting in losses which can be catastrophic.
Once again you can only make money when trading in stock if the value increases.
There is another consideration when trading in stock which is the high cost of owning stock.
Consider buying 200 shares at $25 the cost would be $5000. Should you buy at on the margin it will still cost $2500.
This is large outlay and therefore a large risk; even more so if you take into account you have a 1 in 3 chance of the value increasing.
You also have to consider in the equation the fact that stocks don’t trend in away you can guarantee a profitable return all that often. So you have to be able to pick the right time to invest.
So we can say that trading in stock is not all that easy and it can be expensive.
But options provide a great alternative.
For a start you only have to invest about 2% of what the stock was worth and yet you still control the same 100 shares.
Taking the example above that’s investing $100 instead of $5000.
It also gives you more alternatives and with the right choices you can profit what ever way the stock values move.
Last but not least, your risk is much lower. This is because the most you lose is the amount you invested.
You should also consider the leverage that options give you.
In the above example, if the stock price goes up by $5, the profit on the stock trade would be 10% or on margin, 20%.
However with a similar increase in value an option could increase by about 100%. Your profit would be 100% on the option which is 10 times more than on a straight stock trade.
So by not accepting a commonly held view that the owning of stock is the least risky option you give yourself the chance of learning how to trade using options; opening up a good vehicle for your investments.
We offer the information in this article for educational purposes only. It is not to be used nor is it provided as financial advice. It is provided based on our own experiences of what has worked for us personally. If you are planning to trade or invest in the stock market you should seek advice from a registered licensed advisor.