Controversial Opinion: If you understand options, shares of stock are often obsolete.
That might sound crazy, but hear us out.
Options are truly like a financial Swiss army knife. Options offer a wide array of strategies and uses that can help investors and traders achieve their objective, and manage risk in the process. Traditional shares are a one way street. You buy, and you hope for the best. Options are multifaceted and versatile, allowing traders and investors to take control of their own financial destiny. Before we get into it, let’s dispel a common myth right now.
MYTH: Options are just for gamblers.
The TRUTH: Options are as risky as you make them. Many people think of options purely as tools for stock market speculation. In other words – a bet on a stock’s price. For some inexperienced traders, that’s true. If you spend enough time on Reddit’s Wall Street Bets community, you’ll inevitably encounter option traders who treat their brokerage like an at-home casino. However, if you’re willing to learn the ins and outs of options – to truly master your understanding of them – you’ll soon find that options can do everything stock shares can do, and much, much more. That’s why we’re sticking by our point: If you understand options well enough, you might strongly reconsider your next stock trade.
EXPOSED: Stock-Only Investing Is Riskier Than You Think
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Jon and Pete’s brand-new book It’s NOT an Option (featured above) goes deeper than we could ever go in this article. But here’s a short, incomplete list of things you can do with options at a basic level. With options, you can:
- Hedge Against Risk: Shares offer little protection during market downturns, leaving investors exposed to significant unforeseen risks and black swan events. Options, on the other hand, can act as a shield, allowing you to safeguard your portfolio by effectively insuring it against potential disasters.
- Simulate Shares at a Lower Price: You don’t have to be content with buying shares at current market prices. Deep-in-the-money options offer the opportunity to mimic share ownership at a much lower cost, reducing your financial exposure.
- Speculate for Gains: Just as shares allow you to profit from upward price movements, options enable you to speculate on market directions and profit from both bullish and bearish trends. The flexibility of options can significantly enhance your profit potential, while significantly decreasing your net-risk relative to the stock price.
- Defined Risk: One of the most compelling features of options is that long options strategies offer defined risk. You can never lose more than the initial investment, ensuring you have a clear grasp of your potential losses from the outset of your trade.
Let’s step back for a second – we’re going to make our case in a different way.
Imagine for a moment that, instead of a trader or an investor, you’re a contractor who’s hired to work on a home. You have several complex tasks you must complete within the home. For instance, you might have to grout and tile the floor, put up sheetrock, mud and paint the walls – and you’ll have to deal with any unforeseen problems that may come up along the way.
Would you show up to the jobsite with just one tool?
“Hey, I’m here to remodel your house! I brought my screwdriver!”
“That’s great – where are the rest of your tools?”
“I need other tools?”
Did you hear that? That’s the sound of you getting a bad yelp review.
The example about trying to perform a home renovation with only a screwdriver may sound silly, but that’s how you look when you trade or invest in the stock market with only shares of stock. You’re bringing a single-use, outdated tool to a job that requires a diverse array of equipment in order to do the job right. Instead, options are like an entire toolbox filled with top-of-the-line power tools. Yes – they take a lot more know-how to operate than your standard screwdriver, but once you get the hang of it, you’re going to realize it’s a lot easier and more effective to use a drill.
Have we given you enough metaphors yet? Let’s get serious.
Here are three basic reasons why options are superior to shares of stock, if you know how to use them.
You can protect your investments with options
When it comes to buying insurance on your treasured portfolio, there’s nothing better than options. No strategy can compare to the low-cost, high impact leverage you can receive from options – and it doesn’t take a complex trade structure either. You can make a powerful hedge out of a few long put options, or a few covered calls. Don’t get us wrong – there are some other hedging choices for those who don’t trade options – but as we’ll soon show, options are by far the superior choice for hedging.
For instance, you can short stock. Shorting is another word for selling shares of stock you don’t have, with the intent of buying it back later at a lower price – allowing you to benefit from a drawdown in share value. However, shorting has a few serious drawbacks. For one, shorting requires immense risk. While options carry defined risk, shorting does not, meaning a trader can send their entire account into the negative with one bad short. On top of that, shorting requires a large amount of margin, which means it isn’t accessible to smaller account sizes, and it requires a large portion of capital to remain tied up. Lastly, despite all of the drawbacks, the impact of a 1:1 short still pales in comparison to a 100x leveraged option. The most important flaw in shorting can be learned from Melvin Capital (the hedge fund that infamously shorted GameStop) – the worst case scenario, a short squeeze. In a short squeeze, the rug can be ripped out from under an investment that you thought was going to protect you – and it can have a devastating impact on even the largest portfolios and funds.
Another choice for non-option hedging is an inverse ETF. However, these also come with their caveats, and are also an inferior hedging choice to options. Inverse ETFs are like shorting, however they at least offer defined risk. Some even come packaged with a small amount of leverage. However, like shorting, the leverage offered is costly, and is significantly less powerful than what you can get with an option.
As an example, imagine you have a tech-heavy portfolio, and you fear a particular upcoming earnings event could take your investments for a ride. You could buy shares of the SQQQ, which offer 3x leverage against the Nasdaq ETF, QQQ. However, in doing so you’ll incur a management fee as well as other ETF-related expenses. Or you could buy a cheap, out-of-the-money, long put option with an expiration targeted around the event you’re concerned about, which offers up to 100x leverage.
For equivalent protection, that means you would have to buy 33.33 shares of SQQQ to receive the same insurance that one single option provides. Tying up that amount of capital with inverse ETFs is not only cumbersome for your portfolio, it can even expose you to upside risk in the event that your hedge is too large. Put options don’t have that issue – the amount you pay is a defined risk, meaning you cannot lose more than you pay for the option, and that will almost certainly be cheaper pound-for-pound than what you will pay for equivalent amount of inverse ETF protection.
Long puts aren’t the only way options can protect your investments. You can sell covered calls against shares you own to collect option premium and lower your cost basis. Market Rebellion co-founder Jon Najarian has compared this style of risk management to being a landlord. “Just like you collect rent on an apartment you might own, covered calls allow you to collect rent on the shares and investments that you own.” Covered calls can allow you to make money in three potential ways – dividends (if the stock pays them), capital appreciation (like the value of your home rising over time), and options premium.
However, remember the point we made at the top of this article? You don’t even need shares to collect covered call premium. Remember – anything a share can do, an option can do better (and for less money). That brings us to our second point:
In the fast-paced world of the stock market, traditional stock shares are no longer the only game in town. Now, rather than buying shares at full value, you can simulate those shares with options! Let’s look at an example:
Imagine you’re interested in getting long Apple stock. You could buy 90 shares of the stock, right now, for $15,902. Or, you could simulate those shares for cheaper, using a stock replacement strategy. To do that, you would go at least 3 months into the future (you can use a longer time frame if you prefer), and select an option that is at least 85 delta. The option below is 90 delta, expiring in 92 days, and costs $35.10 – just 22% of the amount you would have paid if you picked up equivalent shares.
In options, delta is essentially a representation of how many “shares” that option represents right now. That means, currently, this option represents 90 shares worth of movement. However, delta can move fast – and if Apple rises, this delta will likely rise as well, up to 100 shares worth of stock.
Now, here’s where options could save you. Imagine a black swan event takes place – an unexpected event that takes the market by surprise, and drags your stock into the depths of price discovery. In our example, let’s imagine that Apple’s price falls to a three year low of about $110. If you were using options as a stock replacement, your option would become nearly worthless – you would have lost all or most of your $35.10. However, if you were using shares, you would have suffered losses that were much greater – your initial $15,902 would now be worth just $9,900 – a loss of more than $6,000. In this scenario, options saved you from significant capital loss.
Now, let’s take the other side. If Apple rallied to $250, your option would be worth $10,500 of intrinsic value, and the delta would essentially be 100, since it would now be extremely deep in the money. That means in this scenario, your option would have gained $6,990. If you were using shares, you would have gained $6,598 – there is no magical increasing delta to add leverage to your shares, so you get the base 90-value. In this bullish scenario, despite risking more than 4X what you would have risked on an option, your shares profited you less money than the option equivalent.
We didn’t cherry pick those numbers – you can sub in your own calculations and scenarios until the day turns to night. The facts won’t change: options offer better protection, more leverage, and more utility than traditional shares of stock. And in this example, we didn’t even get into the advanced strategies you could have used to mitigate additional risk. For instance, an advanced trader may have combined their stock replacement strategy with a far out of the money diagonal spread to lower their cost basis further. However, while we think everyone should become an options master, you don’t have to master options to utilize simple strategies like the stock replacement strategy above.
As we’ve said, this list is about as basic as they come – there’s a lot more you can do with options that we aren’t going to discuss here. But we would be remiss if we didn’t talk about everyone’s favorite thing to do with options: speculation.
You can speculate on stock price movements with options
If you’re familiar at all with options trading, you’re likely familiar with this strategy. Still, to be brief, options are the superior tool for speculating on stock price movement because they offer theoretically infinite gain potential. How infinite? Let’s look at an example from our trade log.
Back in August of 2022, our Heat Seeker algorithm picked up an alert – a massive 6,000 contract trade was made in Coinbase call options – far out of the money, very near dated. We alerted members to the trade immediately. With the stock trading at just $64.90, this trader was taking $80 strike calls that expired in just a week. That means this trader was expecting a big stock move in a short time period. However, because this trade was so theoretically improbable, these option contracts only cost the trader $0.20 per contract. Still, they spent $120,000 on the trade, so we knew they were serious.
48 hours later, news broke: Coinbase had inked a partnership with Blackrock — the largest asset manager in the world. By August 4th, shares of COIN rocketed more than 80% higher, trading up to $116.30 in the first hour of the day. That monstrous move led these once-OTM options to rise 18,350%, as much as $36.90 per contract.
Let’s do some math: if you invested $1,000 into these options on August 2nd alongside the Coinbase whale, you could have been sitting on $184,500 dollars. If you had bought shares of the stock with $1,000, you could have bought 15 shares of Coinbase before the move, and you could have still gained a possible $744.5 (bringing your total $1,000 investment to $1,744.5) – however, while this is good, it pales in comparison to the possible gains of options. Let’s be clear: returns like these aren’t common — but when you’re trading options, anything is possible.
Now right here, this is where some traders get it wrong. They see these big numbers, they understand that anything is possible, and that’s where the thought process ends. They don’t think of the risks, and they don’t understand that more than anything, options are tools for risk management.
Risk management is the most important ingredient for a successful trader, whether you’re trading shares, options, or any other financial instrument. With shares, you have a very limited set of moves. You can buy shares, and you can use margin to increase your leverage (though this comes with the possibility of margin calls and undefined risk – and you won’t get the same level of leverage that you will with options). To manage your risk, your only move is that you can sell shares.
With options, you can utilize a vast arsenal of trading weapons to help you manage risk. For instance, if you are holding a long call option, and the value rises, you can sell a call option against it – called “legging in” to a spread. This caps your potential gain on the option, but returns to you the value of the option you sell in the form of cold hard cash. Instead of “legging in” to a spread, you could also “roll up” a successful option. In a roll-up, you would sell the option you’re holding in exchange for a cheaper, further from the money option at a higher strike, with the same directional bias, in the same stock. This allows you to lower your risk, and lock in some of the profit you’ve accrued, while still remaining in the trade.
Again, this is the tip of the iceberg for options. While this article is only a few pages, it would take an entire book to really understand everything that options can do. Luckily, for traders who are serious about mastering their understanding of options, Jon and Pete Najarian created exactly that.
Get a FREE Sneak Peek at Jon and Pete’s New Book, “It’s NOT an Option”
It took the Najarian bros more than a year of writing to put together It’s NOT an Option, and we couldn’t be more thrilled with the result. This groundbreaking book will show you definitively that trading in today’s market without options by your side is NOT an option. The key takeaway: In a world where uncertainty reigns supreme, and massive risks lurk behind every corner, embrace the power of options trading for a more secure, and potentially more profitable future in the stock market.
Curious? Get a no-risk sneak peek at our book, It’s NOT an Option, right now. Check out the first chapter for free using this link.
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