Why Trade Options Instead of Stocks?
Stocks are the first financial instrument to pop up in most investors' minds when they think about the financial markets. However, in the past few years, options trading has become very fashionable among retail and institutional investors alike. While options might appear to be more complex than traditional stock trading, they possess some tactical advantages which can quite significantly enhance an investor's portfolio. This article explains the reasons why so many traders prefer options to stocks, such as flexibility, leverage, risk management, income generation, and cost efficiency.
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1. Leverage and Capital Efficiency
Maybe the most compelling reason why option trading is superior to stock trading is leverage. Options allow traders to employ a tremendous amount of stock for relatively modest amounts of money. For example, the purchase of one call typically gives the holder the right to buy 100 shares of the underlying stock at a given price.
- If a share is trading at Rs. 1,000, and a call option with an expiry of 1 month and strike price of Rs. 1,020 is quoted at Rs. 30.
- Rather than putting Rs. 1,000 into buying one share, a trader can put Rs. 30 to have that same share.
- If the price of the stock rises to Rs. 1,100, the option would be worth Rs. 80 (Rs. 1,100 - Rs. 1,020) and give a profit of Rs. 50 or 166% return for a 10% return on buying the stock.
The leveraged exposure renders options very popular with traders who intend to squeeze out the highest possible return from limited capital.
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2. Flexibility in Strategy
Options offer unparalled strategic flexibility. You can profit in a bull market, bear market, or even a sideways market using various strategies:
- Bullish: Buying calls, bull call spreads
- Bearish: Buying puts, bear put spreads
- Neutral: Iron condors, straddles, and strangles
While stocks primarily require favorable price action to generate profits (in long positions), options allow you to profit from time decay, volatility changes, or even minimal price action, depending on your desired strategy.
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3. Risk Management and Hedging
Options are an effective hedging and risk management instrument. To see this, if you own a stock and are concerned about a near-term decline, you can buy a put option to protect yourself against your loss. It is a protective put.
- If your stock drops from Rs. 1,000 to Rs. 900, your portfolio loses value.
- But if you have a put option when the strike price is Rs. 980, you can at least sell the stock for Rs. 980, limiting your loss.
Institutions will use options to hedge huge portfolios, and retail investors may similarly utilize similar strategies to cushion against unexpected market fluctuations.
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4. Income Generation
Options can be used to generate consistent returns even in flat or slightly bearish market conditions. The most widespread strategy is the covered call strategy:
- You buy 100 shares of stock and simultaneously sell a call option on the same stock.
- The premium received on selling the call brings income.
- If the stock remains below the strike price, you keep the premium and the stock.
Another cash-producing technique is selling cash-covered puts, whereby you agree to buy a stock at a specified price for a premium. They are excellent tools in generating cash flow while waiting to buy good stocks at lower prices.
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5. Defined Risk
Unlike short-selling shares, where there is unlimited risk in case the share price increases, option buying carries well-defined risk. The maximum loss for a buyer of an option is the premium paid.
- You purchase a call option for Rs. 30 and the stock fails to move in your favor, your maximum loss is Rs. 30.
- This is safer than shorting a stock for Rs. 1,000 and seeing it surge to Rs. 1,500 or more.
Risk-defined makes options attractive for low-risk-tolerance or novice traders.
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6. Volatility Trading Ability
Options provide a vehicle to trade volatility outright. With options tactics like straddles or strangles, traders can profit from significant price moves regardless of direction.
- A long straddle involves a simultaneous purchase of a call and a put with the same strike and expiration.
- When the stock moves substantially in one direction, one leg becomes profitable enough to cover the cost of the other.
Option prices may also be influenced by implied volatility. Skilled traders might employ volatility analysis to find mispriced options and profit from volatility contractions or expansions.
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7. Lower Upfront Cost
For the most part, options trading require less capital to start than trading in the underlying stock.
- You would need to pay Rs. 100,000 to buy 100 units of a stock costing Rs. 1,000 each.
- You can buy an option for Rs. 30 a unit for a total amount of Rs. 3,000 for the same exposure.
The savings in cost allow traders to hedge on multiple trades or strategies without committing large funds.
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8. Tax Efficiency (in some jurisdictions)
Depending on the country and tax system, options could be tax advantageous. In India, for instance, options trading is considered business income, and profits are taxable as such. Through appropriate advisory, traders can structure their portfolio to be most tax efficient using options strategies.
(Note: Always consult a tax consultant before taking decisions based on taxation.)
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9. Diversification of Portfolio
Options introduce a new dimension to portfolio diversification. By including options along with equities, bonds, and mutual funds, investors can build more robust portfolios that are more suited to different market conditions.
- Take care of sector-specific risk through options
- Capitalize on income strategies during sideways markets
- Utilize protective puts during bear markets
This is a skill that reduces the volatility of the portfolio and maximizes risk-adjusted returns.
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10. Effective Utilization of Time and Market Conditions
Option traders can tailor their trades to a specific time frame or market conditions:
- Short-term speculators can capitalize on earnings announcements or news events
- Long-term investors can utilize LEAPS (Long-Term Equity Anticipation Securities)
You can build trades that take advantage of time decay (Theta) or volatility squeeze, and options are best adapted to many kinds of market conditions.
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Conclusion
While stocks are straightforward and the foundation for investing, options provide more flexibility, risk management, and possible return. With fewer capital commitments, well-defined risks, and tactical adaptability, options trading can enhance traditional stock investing as well as exist as a freestanding trading strategy.
All of that being said, options do carry risks and complications. Traders must learn extensively, utilize paper trading accounts to sharpen their skills, and start with basic strategies before progressing to more complex ones.
For a disciplined and knowledgeable investor, options offer a world of potential beyond the reach of standard stock trading.
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Disclaimer: Options trading is extremely risky and unsuitable for all investors. This article must be used for general information purposes only and is not investment advice.
