The pros and cons of trading options vs buying or shorting stock.
Everybody wants to make a killing in the stock market. Buy low & sell high, or even buy high… and sell higher!
The biggest problem for most traders and investors is the cost of entering the game. Many people have heard about the FAANG stocks:
Stocks can be expensive, and in many cases prohibitively expensive. Who wished they owned the FAANG stocks and profited off their meteoric rise the last few years? Well, until they split 20-1 earlier this year, AMZN and GOOGL had regularly traded between $2,000 and $3,000 a share for many years!
To have even bought only 100 shares of AMZN when it was trading at $3,000/share would have required an investment of $300,000! And if following prudent money management rules, (I utilize what I call the 10% rule: never putting more than 10% of my account in any single trade), would have necessitated a total account balance of at least three million dollars!
For just 100 shares!
Again, well beyond reach for most non-institutional traders. However, what if a trader could profit off the FAANG stocks, or any stock, for a fraction of what it would cost to own the actual shares of stock?
And to make it even better, what if you could profit from the move of ANY stock, without ever having to own the shares?
Let’s focus on call options vs long stock ownership. For example, let’s use a more affordable stock, IBM, which at one-point last year was trading at $142 a share. To buy 100 shares of IBM at that time would have cost $14,200. However, a 135-call option, giving the owner of the call option the right to buy 100 shares of IBM stock at $135, could have been purchased for $8.45 a share, or $845 for a single option contract.
The first benefit of options is not just the cost but being able to trade a call option in an account that wasn’t large to purchase the shares. And of course, if the trade doesn’t work out, we’re risking much less, and would most likely lose much less if stopped out.
Now let’s look at our profit to see if the trade is successful. Let’s compare buying 100 shares of IBM at $141.75, vs buying a 135-call option when the stock was at $141.75…with a profit target at $170:
Stock Call Option
Target: $170 Target: $170
Stock: $142 Call Option: 135
Profit: $28.00 Intrinsic Value: $35.00
Profit: $28.00/Sh Profit: $26.55
ROR: 20% ROR: 315%
Real Profit: $ 2,800 Real Profit: $2,655
Real Cost (Risk): $14,200 Real Cost (Risk): $845 ($8.45 per share)
So yes, the stock buyer made a few more dollars, $2,800 vs $2,655, but at what cost? The stock buyer needed to spend and risk over $14,000 vs only $845 for the option buyer. Which means the stock buyer would have needed an account with a balance over $140,000 to follow the 10% risk rule, while the option buyer could have made the trade in an account with a balance of less than $8,500. Again, following the 10% risk rule, a trader could only buy six shares, at $142, in an $8,500 account to only risk 10% of the account.
Do stocks have any benefits over options? While that will depend on your trade plan, in my humble opinion, stocks have only three benefits over options:
- Stocks don’t have an expiration date. They don’t expire.
- Stocks pay dividends.
- Stocks have a better breakeven price.
But I’ll sacrifice those three benefits to be able to trade and look to profit on the movement of a stock without having to buy the shares, and in many cases with 80%-90% less financial risk in the trade.
Now obviously there’s no guarantee the trade will work out, and there is always risk associated with any trade or investment.
At The Pinnacle Institute, we not only teach the Pinnacle method of supply and demand to better time your entries and exits but we will also teach you everything you need to know to trade options effectively.
If you’d like to learn more about the fundamentals of Stock Options, click the link below: