Are options riskier than stocks?
For many years I’ve pointed out all the benefits options have over stocks, from leverage, to increased rates of return, to even being able to have the ability to profit when wrong directionally on the trade.
Yet, for all the benefits that options bring to traders and investors, if you asked people what is the riskiest asset class, the answer would overwhelmingly be…options. While every asset certainly has risk, even “safe” mutual funds, why do options have the reputation of being the riskiest asset?
Well, one of those reasons is…it turns out that the vast majority of options traded expire worthless. So, is that a good thing or a bad thing?
Now in order to expire worthless, options have to have something that no other asset has, and they do…they have an expiration date. So when trading options, you not only have to be right about the trade, you have to be right with the clock ticking. You have to be right, against a deadline.
Stocks not only don’t expire, if you buy a stock, do you care how long it takes to get to your profit target? Most people would say no. And as long as you don’t get stopped out, how long can you stay in the trade? Literally forever. I’ve met buy and hold stock investors that have owned the same stock for 30 years. I even met a gentleman a few years back that told me he’s owned Microsoft stock since it went public in 1986!
Trading stock is like a baseball game…theoretically it never has to end. If you’re down 5-0 in the bottom of the ninth, nobody on base, two outs, with two strikes on the batter…is the game over? Nope. As long as you don’t get the third out, and keep getting hits, you can come back and win, no matter how long it takes. While the odds, or probabilities wouldn’t be great, the game isn’t over. There’s no expiration to a baseball game…there’s no clock ticking. A game ends when a team actually scores more runs and wins. The game will end…but it won’t expire.
You could buy a stock like CROX, which from October 31, 2007 dropped from $75 a share to $0.79 a share by November, 2008! And it did come back…14 years later, in January 2021, it was back at $75! Could you have held on all that time? The stock may have dropped to $0.79…but it never expired.
But if you’re down 21-0 in a football game with thirty seconds on the clock, the game’s over…you won’t even get the ball back three times, let alone score three times.
So while trading stock is like a baseball game, trading options is like football, basketball, soccer, or hockey. You not only have to win, you have to win with the clock ticking. Who remembers that game show from the 70’s, “Beat the Clock?”
Now, the fact that most options expire worthless, is that a good thing or a bad thing? Well, it depends on whether you bought or sold the option.
How do you make money in America? For most people, anything you buy, you need it to go up to sell if for more than you paid for it.
Most Americans are bullish, and buy stocks and/or mutual funds, hoping to sell it for more than they paid for it, if the price rises. But if something you bought drops, and eventually becomes worthless, well, that’s a very bad thing.
However, what if you sold short? Then expiring worthless is a beautiful thing! When selling short you not only want the stock to tank, you want the stock to go to zero! You want the company in bankruptcy before the trade settles!
As I mentioned earlier, the vast majority of options expire worthless, and for those who bought options, if they expire worthless, they not only take a loss on the trade, they lost 100% of their investment.
Stock traders rarely, if ever, lose 100% of their stock investment. Why? Because a stock has to go to zero for that to happen, and most stocks just don’t go to zero.
Zero is zero, right? So what’s the difference? Well, while zero may be zero, when buying call options, which are bullish options giving the buyer of the call the right to buy stock, the stock doesn’t have to get anywhere near zero for the call option to be worthless at expiration. The stock just has to drop below the strike price of the call option.
In the above example, TSLA closed at a demand area at app $210 a share. If a trader bought shares of TSLA at $210, the stock would have had to go to zero for the trade to be worthless.
However, if an options trader bought a 210 call option, expiring in say 90 days, regardless of what they paid for it, the stock would just have to close at or below $210 at expiration for the option to expire worthless. TSLA wouldn’t have to get anywhere near zero for the trade to be a total loss. If the stock did nothing, closed in ninety days where it was the day they opened the trade, the option would expire worthless for a total loss on the trade.
So in other words, say a novice trader doesn’t understand the mechanics of options, time decay and volatility, or what happens to option premium as the option gets closer to expiration, they could be staring at a total loss, without ever getting stopped out on the trade!
So we need to define risk. Are options “riskier” than stocks? Perhaps that’s a personal opinion based on how someone trades them. Options certainly have “different” risk than stocks…but in my humble opinion, when traded properly, they actually present a trader with less risk.
At the Pinnacle Institute we’ll show you not just how supply and demand effects price movement on the stock, but how to effectively trade options so that when an option expires worthless, it could end up a profitable trade for you.
