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Why Trade Stock Options?

Compared to owning (or shorting) stock, options have many advantages, and some disadvantages.

The Advantages:

  • Less capital is required to control the same amount of stock. For instance, 100 shares of a $30 stock would be a $3000 investment. Controlling the same stock for three months with an ITM long call might be a $500 investment.
  • Increased leverage, because less capital is controlling the same amount of stock. Leverage means, for instance, that where a one point move in a stock might make or lose 20% on your investment, the same one point move in an option on the stock might make or lose 100% on your investment.
  • An increased chance for diversification. If you are in a market where you see a chance for three stocks to rise for instance, but only have enough capital to buy one stock, you cannot diversify or benefit from the two stocks you can't buy. Using options, you might be able to take bullish positions on all three stocks, diversify, benefit from any or all of the three, and still keep your risk at a reasonable level for your account size.
  • The opportunity for significantly decreased dollar risk. Although there are option positions that are very risky, there are many option positions where your dollar risk is known in advance, and cannot exceed that amount. If you keep that risk at a reasonable level based on your total account size, such as 1-2% of the account, options can be much less risky than stock ownership, especially if you have trouble taking stop losses on stock.
  • The chance to benefit if a stock or the market DOESN'T do something. With stocks, you must be bullish or bearish, and you will lose if the stock does not do what you expect. There are option positions that can benefit if a stock goes down a little, or does not go up, or goes up but not too much. And others that benefit if a stock goes up a little, or does not go down, or goes down but not too much. These type of positions are known as "neutral" positions or strategies.
  • Options give increased opportunities for hedging. Hedging means to have one position that will gain if another loses. With stock, you might hedge several bullish positions by also buying some shares in a contra index ETF such as SDS for instance. But this ties up a lot of capital. There are option positions that are basically a built-in hedge, such as the neutral positions mentioned previously. Or you can hedge with other options with much less capital than buying stock or ETFs. You can also use options such as puts or short calls to hedge a bullish stock position.

The Disadvantages:

  • Options do not pay dividends. But, for someone who shorts stock, they do not require you to pay out the dividend either.
  • Options have a limited life. You can control and benefit from an option only up until it's expiration date. After that, the option ceases to exist. Stocks have a theoretically unlimited life - you can hold a stock forever as long as the company does not go bankrupt or get bought out. The ability to own a stock forever is not always a good thing, however. If you don't pay attention to the market, or don't use a stop loss, owning stock can cause serious financial damage. Many stock investors have bought stock at market highs, and now they find themselves with all their capital tied up, unable to sell without large losses, unable to take advantage of new opportunities, and it may certainly start to feel like they have owned the stock "forever".
  • Options are not marginable. If you own stock in a margin account, you can borrow against that stock and use the borrowed money to buy more stock or another stock, or pay your bills for that matter. You can't borrow against your option positions.
  • Some option positions require margin. Some brokers call this the "option margin requirement", others call it the "option requirement". Option margin is not borrowing, it is a "set aside" your broker will make in your account to cover the worst possible loss on an option position. If you have a $5,000 option margin requirement in your account, you won't be able to use $5,000 of your account for buying stock or options or making withdrawals, until you trade out of the option position or the options expire. The option margin requirement can also cause you to get an earlier margin call from your broker if the market drops, because the option margin requirement is in addition to the normal ratio of equity to account value required. And if you don't have enough equity in your account, your broker either won't allow you to enter an option position that requires an option margin exceeding your account, or if the broker does allow you to enter the position you will get an instant margin call because of it.

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