In the right cases, absolutely! For fast-moving companies, whether up or down, options trading offers superior returns to owning stocks. Offering higher percentage gains at a lower cost to stocks, options are well worth the few potential dangers that work against them. We’ll delve into the pros and cons of stocks versus options so you can see for yourself.
Options Pros & Cons
Pro #1: Options Leverage Your Gains
It goes without saying why traders have turned to option contracts over the years. Options trading is less focused on buying and holding stocks of great companies, and are more interested in catching big swings in the prices of those companies (both up and down).
An options contract controls 100 shares at a far lower price than actually buying 100 shares of a stock, the optimal options strategy when expecting a big move is to use an option instead of buying shares outright. That allows investors to earn far larger percentage returns relative to their capital, while avoiding the stock market entirely.
This leverage is best seen when an option holder buys call options in an underlying stock ahead of a big move higher. A small rally from earnings can be magnified substantially. And a large move over the course of a year can result in potential returns of 1,000 percent or more, depending on the cost of the option and the implied volatility.
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The amount of leverage can also be determined by the strike price of the options. An option buyer who buys a call option in-the-money selects a strike price below the market price of shares. While more expensive and will result in lower percentage returns than a strike price out-of-the-money, it can increase the chance of the trade working out while still providing leverage.
That’s the kind of leverage that options and futures contracts and options and futures trading are known for. This can also apply to employee stock options, which, as they vest, can create a large boost in the net worth of an employee who put in the time needed for the option to mature. However, employee stock options aren’t standardized, and may result in someone owning shares in a privately-held company where selling out and taking a profit may prove difficult.
Pro #2: Options Allow for Optimal Timing
If you expect a company to report good quarterly earnings numbers the week before it reports, buying options ahead of earnings can allow to capture that gain much better than buying stocks.
A 10 percent move in the share price can turn into triple-digit gains when options are used instead, particularly less-expensive short-term ones. That makes an options trading strategy a better way to profit from short-term moves than simply using stocks, particularly for day trading.
But even if a trader thinks a stock will outperform over the next year, it’s possible to buy options as far out as two years in some cases. While more expensive, these options can still provide a far better return than owning shares as long as the trade plays out the way it’s expected to. Options trading in this long-term space, known as LEAPS, can provide a better return than buying the underlying stock as long as the direction is right.
Pro #3: Options are the Best Way to Bet Against Stocks and Other Assets
If you expect the price of a stock to fall, you have a limited number of ways to profit from that. The most common method is by selling a stock short on the market. That has a lot of flaws to it.
In order to do that, an investor has to borrow shares, and pay a high interest rate to do so. If that company pays any dividends, the borrower is on the hook to pay them. Finally, if a stock does end up falling, the most it can lose is 100 percent, which caps the potential gains for the short-seller of the stock. If the stock rises, however, the short-seller may have to put up more and more capital to stay in the trade.
However, in the world of options, there are number of better ways to bet against shares. An investor may think one of their stocks is likely to have a short-term pullback and could make some extra income by selling covered calls against the shares.
For an investor who thinks shares of a company are going to dive, that investor can buy a put option and bet on the price going down. Put options can return more than 100 percent, and don’t have to deal with the pesky costs of borrowing shares to short. It’s a true win-win scenario, given the lower cost of buying a put option compared to borrowing shares to short, and the fact that the put option can only lose 100 percent of its value and doesn’t require more capital the way borrowing shares does.
Finally, in areas such as foreign exchange, or forex trading, forex traders can buy forex options to bet for or against a currency. All bets on the forex market are a binary bet, so a Dollar/Euro trade is a bet for the dollar and against the Euro. That means options investors in this space are always betting against a currency, showing the power of creating wealth on the short side of the market.
Con #1: It’s Easier to Completely Lose on a Trade
It’s true that in any investment, you can potentially lose all the money you put into a trade. It doesn’t matter if it’s a stock or an option. However, in the options space, it’s easier to lose all the money that goes into a trade. That can happen quickly, too, depending on the volatility of the underlying stock or underlying market.
A stock may languish for some time, but it could recover in time. And if it pays a dividend, it’s even possible to get a positive return on a position that goes down overall.
However, in the options space, a trade that doesn’t play out in the right direction and quickly has a very real chance of seeing the trade expire worthless. That’s less of a problem, as options traders tend to put less overall capital into a stock versus an options trade. In most cases, a total wipeout on a single option position is less than a modest loss on a stock position.
Nevertheless, it’s important to factor in potential losses of this percentage size when considering options trades.
An options trader can lessen this potential failure by buying at-the-money or in-the-money call options. While more expensive, these options have an intrinsic value to them, and as long as shares head higher, that value will grow, hopefully offsetting the declining time value of the trade.
Stocks Pros & Cons
Pro #1: Stocks Can Deliver Great Gains Over Time
All options have a strike date, or date where they expire. Stocks don’t have that impediment. While a great options trade can make a sizeable profit quickly, buying and holding a great stock, or a number of positions in the stock market, for a long period of time can have an even better return.
For example, one of the best-performing stocks of the past decade, Netflix (NFLX), rose over 4,000 percent in that timeframe. An options trader would have had a difficult time capturing that level of gains in the same period, as not all options trades would have played out so well. A day trader could have done well around the company’s earnings season, but may have missed out on other rallies outside those big moving days for shares.
Pro #2: Stocks Pay Dividends
While option trading can produce gains quickly, or can even be used with stocks to create extra income, options don’t pay a dividend, generate any interest, or otherwise create any income when bought.
Investors who buy dividend paying stocks and hold them over time can defer capital gains taxes that options traders have to pay on successful trades. Dividend tax rates are far lower, and companies that can grow their dividends over time tend to see a sizeable appreciation in shares as well.
Over a shorter-term period options may perform better, but the longer-term power of steady cash generation from dividends is an optimal strategy getting into retirement and for a more tax-efficient investment portfolio.
It’s true that options trading can generate income when sold against shares of a company you own, a strategy known as “covered call writing.” Put options can be sold as well, which may require the put seller to buy shares of the underlying stock at a set price. This can also generate income as well using options.
However, this strategy generates capital gains that have a higher tax rate than dividends, and therefore isn’t as capital efficient, unless used in a tax-advantaged retirement account.
Pro #3: Stocks Are Tax-Efficient When Bought and Held
Currently, options trades are treated as ordinary income subject to short-term capital gains taxes. Options that are held over a year can get to the long-term tax rate, but long-term options have a lot of time premium working against them.
From a tax perspective, stocks tend to be the better bet. As long as a shareholder doesn’t sell their individual stocks, they don’t have to pay taxes. That allows the stock to compound its wealth, and if shares pay a dividend, they can earn income off of the trade while waiting for shares to continue growing in value as well. Obviously, this kind of strategy means that trading stock isn’t optimal, given the higher taxes involved.
While some tax-deferred accounts allow for some options trading, most of that is related to covered call writing and cash-secured put selling. These conservative strategies don’t create massive moves, but can help improve portfolio returns, which is why there’s been a large growth in option sellers over the years.
Con #1: Stocks Can Take Years to Recover After a Crash
In a market crash, stocks can take a long time to recover. While individual stocks may go to zero in bankruptcy, a bear market will knock off at least 20 percent of the overall stock market’s value.
That kind high volatility can take years to recover—with the market bounce in mid-2020 being more of an outlier than a guide for future market declines. During the last financial market panic, stocks peaked in 2007, slid until early 2009, and didn’t near their old highs until 2012, nearly five years later. That’s a more typical bear market cycle.
Even without a market crash or bear market in general, individual companies can miss out on earnings, taking on a big loss. That kind of loss can take years to recover from, if at all, illustrating the challenge of stock trading.
Conversely, when options trading, a loss at least occurs and is over quickly. The trade expires worthless, and the trader moves on. For stock investors, there’s often a psychological hang-up over losing positions when an investor doesn’t set a stop loss. They sit in the trade without a real plan other than hoping that the price will recover—or that they’ll take some profits after a bounce.
Can You Make More Money Trading Options than Stocks?
Is options trading better than stocks? The pros of options trading certainly outweigh the cons, at least most of the time, and make it worthwhile to trade options.
However, most of today’s trading platforms allow for both. It’s possible to make money trading options while also building up a lucrative stock portfolio as well. It’s best to focus on trading options ahead of short-term events that may move shares, as well as when a one-year trend is likely and an option can be use to generate superior returns.
For longer timeframes, and for income generation, stocks may be better… but there’s nothing wrong with an investor using both for optimal returns in their portfolio.