How is using options better than straight out buying and selling stock?
Well, to answer that question, it really depends on exactly which options you use. Options have a time component that the underlying stock/index does not. If I have a directional view on a stock, I can select options such that it’s worse than buying or selling the underlying stock — but I can also select options such that they’re better than buying or selling underlying stock.
Let me give you an example
If you are bearish on a stock that’s trading at $100 and you think it will go down to $90, you can be either better off or worse off using options — depending on time.
If the $100 stocks falls to $90 tomorrow — and you bought weekly puts that expire at the closest Friday expiration, then your puts will likely make a greater percentage return than if you shorted the stock outright.
But if the $100 stock doesn’t fall to $90 until one year later — and you bought puts expiring in one year — then even though you were right on your directional call, your puts would decline in value — even though you picked the right direction. You’ll still keep whatever intrinsic value is in that option — so if you bought $100 strike puts and it expires at $90 one year later — that’s $10 worth of intrinsic value — but keep in mind in order to make money – the increase in your intrinsic value has to exceed the time value of what you paid for it — which for a 1 year option — is likely to be a good amount.
So why do you lose time value?
The reason is because when you own options — including puts in this example — each day that it doesn’t do what you want it to do – you lose money. That’s what theta is — time decay. Usually this is a small amount, but closer and closer you get to expiration — particularly the two weeks before expiration, the rate of time decay accelerates.
It’s All About Timing
So as you can see, when it comes to comparing trading options versus trading the stock itself — which can be more profitable? Well, options can be better if your TIMING is right (relative to the rate of time deacay).
If your timing is good — then the money you make from options can be significantly better than the stock itself.
However, If your timing is bad — then you can lose money from options even if you are right on the direction.
But what if your timing is really bad?
Well, what I just explained with timing being really important is what happens when you buy calls and puts — as opposed to buying or selling stock. That’s when your timing has to be spot on.
It turns out that when you SELL options — your timing doesn’t have to be so spot on!
That’s where the real money is made — selling options, not buying them.
The safest way to sell options is through risk-defined combination strategies such as call spreads and put spreads — this is when you simultaneously buy one option while selling another option with similar but slightly different attributes. So it’s the same stock, but the option could be of a different strike price or maturity date).
This may sound complicated at first, but with some real-life practice, it’s definitely something that can be picked up quickly.
Options Allow You To Bet Where the Market Won’t Go
When we say that we bet the SPY will stay above or below a certain point in these podcasts — guess what we’re using to execute that trade? That’s right. We’re using options to take on that market view. In particular, we are selling options — so our timing does NOT have to be perfect. That’s why we call them high probability trades.
These strategies allow you to make bets on where the market WON’T go — similar to the way insurance companies bet that you won’t die. As long as you don’t die, they continue to collect life insurance monthly premiums from you. Similarly, with selling options, you can make a similar bet on the options — betting that the market won’t go above or below a certain level.
Betting where the market won’t go is not something you can do by buying or selling the underlying stock. You can only do it with these options strategies.
In many ways, betting where the market won’t go has a higher probability of success than betting where the market will go. How else do all those insurance companies make so much money? That’s the bet they make. If they tried to bet that you would get into an accident, they would be out of business! Instead, they always take the side of the bet — that bets you will NOT get to accident.
And because of that, options can be a higher probability game because they allow you to make such a bet, whereas buying or selling stock does not allow you to do that.
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