Before you continue reading, you must know that I’m not a financial advisor nor do I pretend to play one on the internet. The opinions expressed in my articles are for general informational purposes only and are not intended to provide specific advice or recommendations. It is only intended to provide education about the financial industry.
When I began studying options, I was often told and considered options a risky investment instrument. Nevertheless, I forged ahead everyday during 4 months as if it was my full-time job. After studying and trading options on a daily basis, I now have a much greater understanding and appreciation for this investment instrument, and find it far less risky than buying stocks.
When buying stocks, you’re making a directional bet. You’re betting that the stock price will go up. It’s the old: buy low and sell high strategy. Easy right? Reality is how do you know when the stock price is at its lowest? When do you know the stock price is at its highest?
The moment you buy a stock or ETF, the price can do one of two things: it can go up or it can go down. If the price goes up, you’re happy until the next day, when/if it goes down. If it goes down, you’re stuck holding this asset until it goes back up and eventually you can sell it for a profit.
With options, instead of buying the stock, you can sell a put at a strike price you feel comfortable owning the stock at. Say the stock trades at $100/share. If you think it’s overpriced but are willing to buy it at $80/share, you could wait until the stock price drops. However if the stock skyrockets, you’ll miss out in participating on the upside. An alternative is to sell a put at $80 strike price, and collect a premium. If the stock rockets up, you would have earned income without having to own the stock.
How is selling a put at a strike price lower than the current stock price better than owning the stock? First, you protect yourself from the downside. Should the stock price drop, you give yourself what I call a “margin of error”. Let’s consider the worse case scenario. If the stock price drops to $70/share, a 30% drop which is comparable to the stock market drop we witnessed due to the Covid-19 pandemic in 2020, your put will get exercised, and you’ll be forced to purchase the stock at $80. That’s a $10 loss per share. Certainly, you won’t be happy, but consider how much more unhappy you would be if you had bought the stock at $100 and lost $30/share. Personally, I would rather own the stock at $80 vs $100/share.
To continue on this scenario, after such a big drop what if the stock price continues dropping to $60/share? You’re no longer content in owning the stock at $80/share if you have to take $20 loss per share. With options, you can roll your put out in time and try to lower your strike price from $80 to $70 or $65 or $60 or even possibly $55 without a debit or possibly for a credit depending on how low of a strike price you select. This buys you more time to be right without actually incurring a loss (at least not yet). Personally, I love the flexibility that options offers me.
Second, if you buy the stock, you need sufficient cash in your trading account to purchase the share. Say you buy 100 shares at $100, that’s $100 x 100 = $10,000. If instead you sell a put, you only need a fraction, generally 25%, in reserve ($2,500). With less money, you can control the same number of shares. Options are trading in lots of 100 shares. Now I don’t taunt this advantage because you’re trading in margin. Margin trading is a double edge sword. This is why financial advisors say that options are risky, but so is crossing the street. To minimize getting run over, you cross at crossroad, waiting for the pedestrial sign to signal, and look both ways to make sure there are no crazy drivers before crossing. The same is true with options or trading on margin. You don’t trade more than 50% of your account, only trade options on stocks you want to own, and do your research on the stock/ETF and market conditions.
I’ve only covered the case of selling a put (i.e. sell-to-open) for three reasons:
- I earn a premium, which generates income on my cash. If you’ve heard the old adage “make your money work as hard as you”, I always wondered how the rich did that. This is one of the ways.
- I can place trades on any underlying (i.e. stocks, ETFs, etc) I want without being stock holding a stock, particularly if the stock price went against me and now I’m stuck holding it because I don’t want to sell at a loss.
- I can stay in cash, which gives me a lot of flexibility. Should the market tank, I can quickly get out with minimal loss.
I covered one way of trading options that I personally find to be more effective than buying stocks. I hope this helps you better understand how to leverage this instrument to build your wealth.
Let me know if you found this article helpful. Happy trading!
