If you've never traded options before, you might be wondering why you should start. The simple truth is that options offer several appealing advantages over stocks -- even for true rookies who are just playing straightforward call- and put-buying strategies. Here are four advantages of stock options that might convince you to try your hand at calls and puts.
This is simple arithmetic: options are cheaper to buy than the stocks from which they derive their value. If a stock is trading at $50 per share, it would cost you $5,000 to buy 100 shares. By contrast, one at-the-money call option affording you control of 100 shares might cost $200. Whether you've purchased 100 shares or one call option contract, you're long 100 shares of the stock. However, when you buy the option rather than the stock, you lower your cost of entry dramatically. As a result, you're not only risking less, but you're also leaving more investing capital free for other opportunities.
That lower cost of entry provides a great segue into our next options-related benefit: leverage. Because an option is cheaper to buy than the equivalent amount of stock, there's greater potential for impressive percentage gains on your investment. Again, this is just basic numbers -- it's simply a lot easier to double your money on a $200 investment than a $5,000 investment.
The uninitiated might incorrectly assume that options are inherently risky. Myths abound regarding the potential pitfalls of options trading, and the very mention of the word "derivatives" is enough to give some investors bad flashbacks to the financial crisis of 2008. However, if you're buying puts and calls, you're actually risking less capital than if you traded the stock directly. In a basic option-buying strategy, your maximum potential loss is limited to the initial amount you paid to buy the contract(s). Yes, you do risk losing 100% of your investment if the trade should turn against you. However, to return to the above hypothetical -- if the stock tanks to zero, you'd probably rather take a 100% loss on your $200 call option than a 100% loss on your $5,000 worth of shares.
For the most part, stock traders have two choices: long (bullish) or short (bearish). Conversely, options players have a wide variety of strategies at their disposal. Calls and puts can be combined in myriad different ways to profit from any type of price action: bullish, bearish, sideways, and anywhere in between. Seasoned speculators might ignore price action altogether, and instead use options to profit from dividend payouts or changes in implied volatility. Plus, options can be sold to generate income on existing stock positions, or to set the cost of entry on a planned share purchase. Rather than limiting yourself to the stark black-and-white palette of stock trading, you can use options to fine-tune your approach for any market environment.