A lot of beginner traders ask me this question: should I trade options or stocks?
It may be difficult to choose one since both seem like attractive choices.
The truth is that it depends on which one suits you better. Everyone has different preferences, and both options trading and stock trading can prove to be profitable if you are willing to learn and master the craft.
A lot of beginner traders may choose to trade stocks because it is more commonly discussed and has a better presence in popular culture, especially due to the influence of famous stock traders like Warren Buffett (although Warren Buffett also sells options).
Having said that, there are quite a few advantages to trading options compared to trading stocks.
This article will talk about 3 of those advantages and why they are so important in helping you become a successful trader.
1) Reduced Risk
Risk is one of the most important aspects of trading. Whether it is options, stocks, or forex, to be a good trader you need to know how to manage your risk to profit in the long-run.
When trading options, there may be circumstances where it is riskier when compared to owning equity.
However, when selling options is done properly it reduces risk by allowing you to collect premium and allows you to buy or sell the underlying security at a better price than the current market price.
Plus, you can actually buy options to reduce risk and / or you can sell puts, and then get assigned stock if you believe that there's significant upside potential to owning shares.
Options also need less financial commitment when compared to stocks, and they can also be less vulnerable to the movement in the underlying stock.
Furthermore, when selling an option, you can structure your trades in a way where your risk is defined (such as by selling a vertical credit spread).
This is in stark contrast with buying stocks. When purchasing stocks, a trader would set a stop loss order to prevent heavy losses, and this stop loss order will be triggered at or below the price level set by the trader.
When selling options, it's possible to win up to 98% of your trades.
2) Greater Returns
Profit is an important part of trading (although I also think that minimizing drawdowns and portfolio volatility is more important).
Learning and mastering the art of trading is both difficult and requires a lot of discipline.
Why should someone spend so much time and effort trading if the rewards are not worth it?
For those of you who want the best returns on your investment, then options trading may be the trading strategy for you.
You don’t need to be a genius to understand why options trading has such great returns on investment.
When options trading, the amount of investment needed to trade options to achieve a certain level of profit is much lower compared to when buying stocks.
When selling naked options, you're able to control about 2.5x as much underlying shares as you would when buying stock.
When selling vertical credit spreads, you can structure your trades so that you're controlling ~5x as much stock, with defined risk, as you would if you had decided to buy stock.
This leverage allows some option traders to earn about 35% annually. However, leverage cuts both ways, and if you trade too large, then you can end up losing significantly more money than if you'd decided to only buy stocks.
3) Make Money in All Market Environments
Another reason why options trading is more advantageous when compared to stock trading is the ability to trade and profit in any market environment.
It does not matter whether the market is in an uptrend, a downtrend, or a sideways market.
With a good trading plan and strategy, you can make money anytime when trading options.
This is because when selling options contracts, you profit from time / theta decay.
It's also important to BUY OPTIONS during periods of complacency and when volatility is low.
When selling an out of the money option, as long as the underlying stock price doesn't challenge your strike price, then you should profit from the position (as long as there's not a large volatility expansion).
However, stock trading is not as flexible. For investors to profit in the stock market, they have to buy low and sell high.
This is only possible when the market is going upwards (otherwise known as a bullish market).
Long stock holders will likely lose money in a down trending or bearish market and they will likely not make money in a sideways market.
To conclude, if you are a beginner looking to learn, then options trading can be much more advantageous compared to stocks trading.
Trading options properly will help reduce your risk while also providing higher profit potential.
Finally, the flexibility of options means that you can profit in any market condition assuming that you did your due diligence and have a solid trading strategy.
Frequently Asked Questions (FAQs)
Which is better, trading stocks or trading options?
It depends. Options are leveraged derivatives and the potential is there to earn significantly more, but traders can also lose a lot more.
If traders have a disciplined trading strategy, and buy options during certain times, then trading options is best.
If traders seek to hit home runs and are not disciplined, then buying an index fund is best.
Why is options trading better than trading stocks?
Trading options is much more capital efficient than stocks, it also allows you to make money in all market environments.
Options traders can also obtain shares of stocks at a discount to the current market price.
Disciplined options traders can also reduce risk when compared to trading stocks.
Why is trading stocks better than trading options?
There's less time commitment to buying stocks. Investors can basically "buy and forget".
Additionally, there tends to be less portfolio volatility since many options traders do not properly hedge their accounts.
Is options trading more profitable than stocks?
Trading options can be more profitable, but it's also more risky and traders needs to properly hedge their accounts.
Why buy options instead of stocks?
Options are more capital efficient and provide greater leverage.