Can options actually be safer than stocks? How can stocks actually be riskier than options?
Yes, option trading can be risky and you can lose all your money in option trading. We have discussed all the reasons why option trading can lead
to a catastrophic loss of trading capital in Option Trading Risks
However, option trading can also be safer than stock trading and stock trading can be riskier than option trading!
As we all know by now, "risk" in the stock market sense simply means the probability of a loss of trading capital. Here, we will explore the
scenarios in which stock trading can result in a higher probability of loss (higher risk) than option trading.
Why Stocks Riskier Than Options : Leverage
Shouldn't the higher leverage of stock options make it riskier than stocks? Yes, if you abuse leverage and no if you use leverage the way it should.
Remember, stock options allows the option trader to control the same amount of stock at only a fraction of the price of the stock. This means that
in option trading, you risk a much lesser amount of money for the same quantity of the underlying stock, dramatically reducing option trading risk!
Example : Assuming QQQQ trading at $43.57 and its Jan $43 Call costs $1.63.
You could buy 100 shares of QQQQ for $4357.00 or you could spend only $163 on its
Jan $43 Call and also control the profits on 100 shares of QQQQ. While the most you can lose on the
QQQQ shares is the whole $4357.00, the most you can lose on the call options is only $163.00.
Leverage becomes dangerous when you abuse it by putting the whole $4357.00 into the call options! That's the biggest mistakes
most make in option trading.
Why Stocks Riskier Than Options : Short Selling
The only way a stock trader can profit from a downwards move is by "Short Selling". Short
selling is selling in advanced
stocks that you do not own. What this exposes the trader to is an unlimited amount of loss should the stock rally all of a sudden, running
the short seller into margin
problems. In option trading,
you could simply buy put options to profit from the same drop but yet
limiting losses to only the price of the put options!
Why Stocks Riskier Than Options : Single Directional
Example : Assuming QQQQ trading at $43.57 and its Jan $43 put costs $0.70.
A stock trader shorts 100 shares of QQQQ and the option trader buys 1 contract of Jan $43 Put for $70.
If QQQQ rallies to $50, the stock trader loses $643 but the option trader loses only $70.
In stock trading, you either make money when the stock goes up or down (when you short sell) but NEVER in both directions
at the same time. In option trading, there are option strategies
which profits from BOTH up or down moves, up or stagnant moves, down or stagnant moves and even when the stock remains totally stagnant! The more
directions you can profit from, the higher the probability of win and therefore the lower the risk.
Why Stocks Riskier Than Options : No Hedge
The most popular strategy in option trading to profit from both an up and down move is a Long Straddle.
Hedging is the practise of reducing risk by taking one market position to offset the risk in another. In stock trading, the only way to hedge your position against risk is to manage and diversify your portfolio. In option trading, you not only
can manage and diversify your portfolio, you can also hedge options with options and even hedge stocks with options! Read about How To Hedge
Why Stocks Riskier Than Options : Conclusion
The most popular strategy in option trading used to hedge stocks is a Long Put Option.
As you can see, stock options, being a more advanced financial instrument
than stocks itself has a lot more safety possbilities in it, making option trading safer than simply trading stocks. However, anything good can be abused
and abusing the leverage effects of stock options has led to the popular myth that option trading is extremely risky. Just as crossing streets
can be life threatening if one don't obey traffic rules, option trading can be extremely dangerous if one don't obey the rules of leverage. However,
when leverage is respected and used properly, option trading can indeed be a lot safer than stocks.