A 2020 Yahoo Finance-Harris Poll said that only 23% of retail investors trade options
- Stocks and options are the two most popular alternatives for retail traders.
- You can make money if a stock’s price rises or the company pays dividends.
- With options, you can make money if the stock price moves in your favor, volatility increases or simply because time passes.
Arguably, the two most popular alternatives for retail investors in the financial asset world are stock and options. Essentially the choice between owning and trading the stock itself, or turning to the derivatives market that lies beneath the stock to trade the option contracts in that market.
So how do you choose between the two? To help make that choice, it’s helpful to look at the potential returns associated with the products themselves.
Making money with stock
The strongest benefit of using stock to make money is the product’s simplicity. When you own shares of stock in a company, you make money if the stock goes up, lose money if the stock goes down and collect any dividends the company might pay to its shareholders.
So your returns are driven completely by the stock price and dividend payments—that’s it. While anything can (and at some point will) happen in the short-term, if the company prospers over the long-term, you can reasonably expect its stock price to rise and its dividend payments to start or continue. If, however, the company falters in the long-term, then its stock price will almost surely suffer, too. This is how you make money through stock ownership in a nutshell.
Making Money with Options
First and foremost, options are much more difficult to understand and master than stock, so that might be their biggest drawback when it comes to consistent profitability in this space. The knowledge hurdle to jump over to become proficient with options isn’t short, but while the learning curve with options is steep, the potential reward is equally as significant.
With stock, if you get the directional move in the stock right, you make money. If you don’t, you don’t. With options, if you get the directional move in the stock right, you still make money, but even if you happen to get the directional move wrong, you can still make money. This is largely because in addition to the directional move in the stock, the profit on your option position is also driven by the passage of time and changing volatility—two metrics that oftentimes have nothing at all to do with the stock price itself.
Therefore, options offer a distinct advantage over stocks in that you simply have additional ways to make money that aren’t dependent on the stock price moving. Yes, with a dividend paying stock, you can collect dividends and make money without the stock price moving. But first, it’s important to remember that not all stocks pay dividends. And second, any upcoming dividends to be paid by a company will be factored into the extrinsic value of the options. So as a premium seller, you are still compensated on your positions for any upcoming dividend payments that shareholders are able to enjoy.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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