Pros and Cons of Options
Understanding how options work and when to use them.
Options are probably the most misunderstood of all the asset classes, and in some cases for good reason.
Stocks, ETF’s, futures & forex are directional trades. Get the direction right, you make a profit. Get the direction wrong, you take a loss. Pretty simple.
However, options are the only asset where you can be wrong on the expected directional move of the trade and still make a profit. You can enter a bullish options trade, the stock goes down, and you can profit. You can enter a bearish options trade, the stock can go up, and you can make a profit.
You can be wrong… just not really wrong! For new options traders this is one of the hardest concepts to grasp.
A stock price is the stock price, because it’s the stock price. You’re either buying or selling the stock at the current price, again, because that’s the price. You’re trading the stock at its intrinsic value, what its worth at that moment in time, no more no less. Options also have intrinsic value, what they’re worth intrinsically.
However, options have something stocks don’t have…in addition to intrinsic value, options have extrinsic value. When trading options you’re buying or selling them for more than they’re worth intrinsically. Why?
Options have an expiration date, a date in the future that the trade, for a profit or loss, has to be completed. Aside from buying or selling the intrinsic value, you’re also buying or selling time, and it’s the value of that time, which is guaranteed to melt away as the expiration date arrives, which allows options to be the most flexible asset to trade.
Stock traders only need to be concerned with the where, whether long or short, where do I think the stock will move to profit? Options traders not only need to be concerned with the where, but also with the when.
So the question isn’t whether to use options or not, that’s a personal decision for each trader to make, but rather, when using them… how to use them.
As with most things trading, the decision on what type of option strategy to use depends on what your goal is for the trade, and what you’re expecting the underlying stock to do. So let’s give a brief overview of the pros and cons of options vs stocks.
Stocks only have three advantages over options:
- Stocks don’t expire.
- Stocks have a better break even price.
- Stocks pay dividends. (At least the ones that do)
- Can profit on the move of a stock even when wrong directionally.
- Can profit even if the underlying stock doesn’t move.
- Can profit on the move of a stock without ever having to buy the stock.
- Can profit on the move of a stock where a trader couldn’t afford to buy the stock.
- Can profit on bullish or bearish spread trades with a maximum risk of less than $5/share, no matter how wrong you are.
- Can lose on a trade even when right directionally.
- Can lose on a trade even when the stock doesn’t move.
- Can run out of time for the trade to work out.
People have been trading stocks for over a century, yet while options have more moving parts than stock, they also have more ways to profit when used properly.
The key is to understand the option’s moving parts, and knowing when to utilize each strategy based on their ability to help you profit.
While options may give you more ways to profit vs stocks, there is no such thing as a guaranteed profitable trade. Proper risk management is as important as the mechanics of any trade.
Additional resources to learn more about the basics of options: Options Basics | PINNACLE INSTITUTE
Steve Moses Options 101: Options 101 with Steve Moses May 27th, 2022 Trading Options #tradingtips Supply and Demand – YouTube