Building an investment portfolio requires you to be familiar with different trading and investment instruments. While stocks are the most common form of investments, you would ideally want to make your portfolio more diverse. To do so, many people use a mix of stocks, commodities and options to make up their portfolio, and rely heavily on options trading to generate portfolio returns. But, is this method right for you, too? Can options trading be more profitable than stocks?
Options, being leveraged instruments, can be more profitable than stocks, but they are also riskier. Stock trading is better suited for the long term investors or for traders with large trading accounts. For short term trading and for traders with small accounts, option trading is more profitable.
To make an informed decision on choosing between the two, you will need to know about the differences between the two financial instruments and have some working knowledge of investment principles that both these instruments revolve around. Make sure to keep reading if you are working towards building a profitable portfolio.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Are Options and Stocks?
When it comes time to build your stock portfolio, you have two main trading instruments to choose from. These instruments are options and individual stocks. If you know and understand the differences in investment methodology behind both these instruments, with some effort and time, generating returns and a profitable portfolio is not something you would struggle with a lot.
While options allow for faster-paced trading with more profits, stocks give you dividends over time. Some people prefer to use only one versus the other, while others make use of both these trading instruments in their portfolios – each serving a different investment purpose. You may want to consider your preferences as you read through the differences between both these instruments.
Options
According to the SEC, an option is an “opportunity” to buy or sell assets. This means when trading options your goal is to buy these contracts at a low premium, and sell them when you feel the premium is right. Options trading requires you to know what you are doing and pay attention to daily asset prices, along with the price of the option itself.
Additionally, since buying options merely gives you the right to buy or sell the underlying asset at a predetermined price, you have control over a much bigger position in options trading when compared to simply buying the underlying stocks. Hence, trading options can be much more profitable than individual stocks, when traded correctly.
That being said, with leverage comes higher risks. Hence, options trading can also be a very risky business, when performed without proper understanding of the market and risk management. To trade these instruments profitably, you will need to be familiar with the market timing and time decay:
- Market Timing: Options come with an expiration date. Hence, to profitably trade them, you have to be right about the timing of a security’s price movement, in addition to its direction. Hence, trading options comes with this additional layer of complexity that is usually not as critical in stock trading.
- Time Decay: Options decay in value with time even if there are no changes to the price of the security they give you the right to purchase or sell at a predetermined value. This is because option value is composed of two factors – the intrinsic value of the security that they allow you to control, and the time for which they allow you to control that security. Therefore, to profit from options, one needs to be really precise about the timing of price changes in addition to its direction.
To summarize, when it comes to options trading, there is a lot to consider. Every time you trade, you need to consider three different factors:
- What direction is the stock moving now?
- How high or low will it go?
- How long do I have for that to happen?
Those familiar with options come up with advanced strategies to earn the most profit. You may want to start small and build your way up to more significant trades, which will ensure you are familiar with the process first, and considerably lower your risk.
To summarize options trading, you want to act quickly to earn the most profit, which can be lucrative but difficult for people to adjust to. Once you learn the market timing, you can respond to time decay efficiently, allowing you to make money.
Stocks
Many people are more familiar with stocks. Stocks, or equities, are security that shows you own a part of a company, which entitles you to a portion of the company’s assets. The amount you own is proportional to how much stock the company has. In other words, buying stocks makes you an owner of a business.
Stocks are different from options, in that the company sells them to investors, who then trade among themselves. During these exchanges, the value of the stocks comes out, which can go up and down. Overall, the goal in stock trading is to buy and sell individual company shares to make a profit.
Due to the lack of leverage that options offer in buying stocks for cash, the process of stock trading is slower than options trading, which is the biggest downside. You might hold onto a piece of stock for a year, which is much longer than you’d want to keep an option, as they can take a long time to develop a good profit. But, many stocks do offer dividends. And, they are less risky since you are more likely to notice good times to sell in the market.
If you don’t enjoy waiting around or letting money sit, and your overall objective is to make quicker profits, then options might be more suitable instruments to trade for you. You are the only person who can decide this, however.
This video further explains all of the differences between these two trading forms:
Why Options Offer More Profit?
Options are more leveraged than stocks, meaning you only need a portion of the amount you want to trade. Think of it similar to companies building assets on borrowed money. It adds to their overall risk exposure, but dramatically increases the potential return of their investments as well. Similarly, options come with more risk and more reward because of this leverage.
Options can expire, but if their value goes up before they do, you make a substantial profit. But, they are worthless after they expire. In short, options can be more profitable but are still the riskier of the two instruments. That being said, you can be in a fantastic position to generate meaningful returns trading options, once you understand how they work and how to manage the added risk associated with options efficiently.
You may want to read and learn as much as you can about options trading before you start. The book Options Trading by Nathan Real offers a complete beginner’s guide and an A to Z glossary of all the terms you need to know.
Can You Invest in Both – Options and Stocks?
You can invest in both, but it all depends on your preferences and your trading strategy. If you want to focus on a long-term investment, you should buy and hold stocks. But if you want to be more active in earning a profit and generating higher returns, options trading might be more suitable to you.
Trading both these instruments at the same time takes a lot of dedication and patience. However, you are diversifying your portfolio even further, which is excellent for managing risk. As long as you treat the two differently, you should have no problem earning from them.
Which Is Better for You?
Choosing between options trading and stocks can be difficult, especially when you are new to the world of investing. You might want to try options trading when you feel comfortable with it, because the potential for profits is much higher, making it more worth your time to learn. It is also more engaging for active traders. As an absolute beginner, learning how to trade stocks first, might give you a better shot at being successful.
If you are already invested in stock trading, you should still add some options trades to your portfolio. These options can be a part of your hedging strategy or simply to generate additional returns. In essence, hedging is the process that involves reducing risks that come with stocks. Hedging won’t make you more money, but it protects you from losing what you have invested in shares.
At the end of the day, only you can choose the investment type that suits you. Make sure to consider your trading style, risk preferences, and what you are comfortable with. However, if you pick one and don’t like it, you aren’t locked into that forever! Plenty of stock traders switch to options trading or use both methods.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
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Conclusion
To summarize, options trading is much more profitable than stocks. Being a leveraged instrument, they can potentially provide you with higher returns. While you don’t get to own a piece of the company with options, they are more than worth your time to learn.
Additionally, you must note that options come with more risk. But you can easily manage and lower that risk if you do your homework right and are prepared to trade these instruments. If options trading is an area that interests you, I have many more posts written on this subject. Be sure to check those articles out on TradeVeda to learn more about different options trading techniques.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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