Why Stock is More Risky than Options!

by David Chandler

Published on this site: August 2nd, 2005 - See more articles from this month

You probably realize by now that our trading preference is stock options.

But you have probably been told or read that options are risky. Even worse, that you can lose your shirt trading them!

Well, what is the truth?

Let's take a look at stock ownership. What can happen if you buy stock?

The price can go up.

The price can go down.

The price can go sideways.

In the first case, you can make money. In the second you lose money.

And in the third case you don't directly win or lose but in fact it costs you money in two ways. The direct cost of brokerage and fees. And the indirect cost known as opportunity cost.

This is the cost due to lost opportunities. The fact that you aren't able to be involved in other, potentially profitable trades.

So if you purchase stock you can only make money if the stock price goes up.

Now some of you may be thinking, But what about shorting?

Well yes, short selling stock is possible but it is quite a tricky strategy and has almost unlimited risk so it is certainly not an approach we recommend.

You see, when you short a stock, you actually sell a stock that you don't own. And your intention is to then buy the stock backat a lower price. The price difference is your profit per share.

But can you see what the problem is here?

Well what happens if the stock price goes up? Particularly if it goes up a lot?

As you have sold the stock at a lower price you now have to buy it back at a higher price. And so your loss can be substantial.

So, to summarize, when you trade stock you can really only make money if the price increases.

Now there is one other aspect to this that I want to address. And this is that owning stock is expensive!

If you purchase 100 shares of a $50 stock it will cost you $5000. And if you buy it on margin it is still $2500.

That is a lot of money to outlay. And, more importantly it is a lot of money to put at risk. Especially seeing that you only have a one in three chance of the stock moving in the right direction.

Plus as stocks don't trend all that often you not only need to pick the right direction, you also need to be able to pick the right time.

So stock trading is not that easy. And it's expensive.

But options provide a great alternative.

For a start you only have to invest about 2% of what the stock was worth and yet you still control the same 100 shares.

So in the example above, instead of investing $5000, we might only have to outlay $100.

Plus, if you select the right strategy, you can profit no matter whether the stock price goes up; goes down or even goes sideways!

And finally, your risk is limited. The maximum you can lose is the amount you put into the trade. So in the example above - $100.

But the best thing of all is the leverage that options provide.

In the above example, if the stock price goes up by $5, the profit on the stock trade would be 10% or on margin, 20%.

But with this increase in stock price the value of the option might increase by 100%. And so the profit on the trade would be 100% - or ten times that of the straight stock trade.

So don't just accept the common view that owning stock is safe and trading options is dangerous. If you understand options and learn how to trade them they can be a great investment vehicle.

The above comments are offered for educational purposes only. We are not providing you with financial advice. We are simply sharing with you what has and hasn't worked for us personally. If you wish to trade or invest in the stock market you should obtain advice from a registered licensed advisor.



David Chandler http://www.stockmarketgenie.com For your FREE Stock Market Trading Mini Course: "What The Wall Street Hot Shots Won't Tell You!" go to: http://www.stockmarketgenie.com