Most traders that do not have familiarity with equity options hold some common misconceptions about the amount of risk and capital associated with actively trading equity options. The notion that options trading is overly risky or requires a trader to invest a large amount of capital to hold a position is completely misguided. In reality, equity options offer a trader superior risk management capabilities and a higher profit potential. Here we will discuss how traders can benefit from trading options and can use them to trade better risk reward setups.
Before a trader can understand how options offer them a more efficient way to express their market views they need to understand the benefits of inherent leverage.
Leverage Is My Friend, Not My Enemy
The first and most obvious benefit of trading equity options over the underlying stocks is the risk management capabilities they offer a trader. To understand how options offer a trader a better risk management approach a trader needs to understand how options actually work. Most of the misconceptions that traders hold come from a lack of understanding in how the actual product works.
Equity options are derivatives contracts that give the buyer of the option the right but not the obligation to buy or sell a certain underlying security at a specified price and specified time. Sellers of equity options have the obligation to buy or sell the underlying security at a specified time and price. The cost of this right is the options premium. While the risk management considerations are different for buyers and sellers of equity options the sellers generally carry more risk. In this piece we will mostly be discussing options from the perspective of the options buyer. Let’s look at an example of an options trader and break down the trader risk and reward potential.
Trade: A trader buys the XYZ Jan 100 Calls for $1.00
Maximum Risk: $100 per 1 lot
Maximum Reward: Unlimited
Breakeven: $101.00
Every options contract gives the buyer the right to buy or sell 100 shares of the underlying at a specified time and price. Put options give the buyer the right to sell and call options give the buyer the right to buy. In this case the trader is paying $100 ($1.00 x 100 shares) for the right but not obligation to buy XYZ shares at $100 on January expiry. The trader paid $1.00 for the contract so they would need the stock be over $100 for the trade to profit. Since stocks can technically have an infinite upside potential this trade does not have a bound on profitability. Let’s compare this to a trade in the underlying stock.
Trade: A trader buys 100 shares of XYZ stock for $100/share
Maximum Risk: $10,000
Maximum Reward: Unlimited
Breakeven: $100
In this case a trader’s breakeven point is lower than it is in the options trade. The trader’s risk is also much higher. The main benefit of trading the stock instead of the options is that if the stock does not move the trader will not experience a loss. Since options have an expiration traders can lose money if the stock does not move quickly enough. This is one of the reasons that most traders think that options are riskier than stock. If stocks do not move options traders can still lose money. However this is a fair trade off considering we can take the options trade with 100 times less risk that the stock trade would require. The options trade also controls the same amount of stock but for 1% of the capital needed to buy the underlying outright.
While options traders can lose money if the stock does not move, an options buyer cannot lose more than they paid for the option. The inherent leverage that options provide actually lowers risk for traders. Many traders are scared of leverage and what it means for their potential losses but as you can see clearly illustrated above, when used properly, leverage actually lowers overall risk. This become even more obvious when we compare puts to short stock.
Trade: A trader buys the XYZ Jan 100 Puts for $1.00
Maximum Risk: $100 per 1 lot
Maximum Reward: $9,900 per 1 lot (if stock goes to 0)
Breakeven: $99.00
Trade: A trader sells short 100 shares of XYZ at $100/share
Maximum Risk: Unlimited
Maximum Reward: $10,000 (if stock goes to 0)
Breakeven: $100
The risk reward benefits of options are even more apparent in this case. To carry a short position in the underlying stock a trader would expose themselves to unlimited losses. The options trade allows a trader to take a speculative short position with nearly the same reward potential and a limited level of risk. Again, options cannot be worth less than 0 so the options trader can never lose more than the premium they paid for the position.
Leverage is your friend, not your enemy. Don’t let someone tell you that options are riskier than stock. If someone says that to you they simply don’t understand what they are talking about. While risk might be elevated for options sellers, options buyers benefit from what is essentially a built in stop. The fact that options contracts cannot be worth less than 0 also brings us to the next major benefit of trading options over stock. Staying power.
The Staying Power of Options
The next major benefit of trading options is staying power. If a trader is trading the underlying stock they may choose to use a stop loss to limit their risk and exposure. There are 2 main drawbacks to trading equities with stop losses.
- The stops may not hold – Equity markets do not trade overnight. This means that they are prone to gapping. A gap happens when the underlying market opens significantly higher or lower than the previous day’s closing price. This can make traders stops completely pointless. If the market opens through the traders stop they have lost more than they thought they could in the position. This happens more often than you might think.
- Once stopped out a trader no long participates – After a trader is stopped out of a position in stock they cannot participate in any potential rally or reversal back in their favor. To do so they would have to re-enter the position taking on more risk that they originally wanted to in the trade. Options provide a solution to this problem because even if the options contract goes to 0 before expiration the trader is able to stay in the trade knowing it cannot be worth less than that. This allows a trader to participate in any recovery or favorable move in the underlying without having to add to the position and take on more risk. This is especially beneficial for traders with smaller accounts that do not have the ability to add to or re-enter positions they have been stopped out of.
This aspect of options is more valuable than you might realize. If you are stock trader think about how many times you have been stopped out of a position only to see the stock reverse and move back in your favor. Using options will give you the ability to stay in trades longer with less risk. All the while you are still benefiting from the inherent leverage and risk management capabilities of options.
Conclusion
While there is a myriad of other reasons to trade options these two aspects discussed in this article should be enough to change your mind if you had a negative opinion of options before. Leverage is not something to be afraid of. If used properly the leverage options provide can be used to take on positions with less risk and more overall profit potential. They also allow a trader to maximize their staying power in a trade. These are two dynamics that benefit every trader, not just traders with large accounts and large amounts of risk capital on hand. Regardless of your trading situation you should really consider trading options. The benefits of options will become obvious after your first couple of trades.