As you may already know, Options have a unique, non dollar for dollar pricing structure, they offer the best risk / reward ratio for investing and short term trading alike. Stock Option trading is all about taking that unique pricing structure into account and planning an investment strategy with it.
Stock Options offer high leverage, depending on the underlying stock and the implied volatility of the market, the Options offered on a stock may be cheap or expensive. Regardless of this leverage however, the main reason why investors turn to stock Option trading is NOT because of the leverage but because of their asymmetrical profit – loss relationship, as well as their tolerance to price extremes that usually results in stop running in all Futures contracts positions.
Case in point: How stock Option trading would have saved the day during the flash crash seen on this chart:
Assume you were an investor during that flash market crash day, having invested in Apple (AAPL) stock, if you had bought 100 shares of the actual stock, at the $245 level in the days preceding the crash, you would have paid $24,500! You would not be affected by the daily crash, however you would be risking your money dollar for dollar as the stock rose or dropped by $1.
If you had bought Futures contracts or CFDs, the mini crash would throw you out of the market completely unnecessarily, and resulting in a significant loss, depending on your stop loss order, but certainly at least $12 in terms of stock price movement.
Finally, if you had bough a Call Option on (AAPL), you would have paid, depending on the exact Option contract, anything from $2,000 to $16,000. (Expensive Options are more in the money and tend to move in a more dollar for dollar way than cheaper Options). But let’s assume you bought a just in the money $8,000 Call Option with a Delta of 0.5. If the stock rose from $245 to $265, a $20 gain, your Call Option would then be worth around $9,500, long before expiration. That would have been a $1,500 gain, but if the stock dropped $20, you would only lose $1,000 and not $1,500!
In this case the stock dropped too much for the day and later fully recovered, unlike the Futures contracts no unnecessary losses would have been incurred, and unlike the stock investor, the more the market dropped the less you would be losing, allowing you enough spare capital to consider buying yet another Call Option at the $200 level. If you did buy another Call Option at the $200 level, then over the next 2- 3 days you would have made over $3,000 without having to worry about stop loss orders and capital at risk.
Bottom line about stock Option trading:
Stock Option trading can be extremely favourable as long as you create a mental stop loss level, where at that level your Option contract becomes out of the money (OTM). Once an Option is (OTM), the market can keep moving against you but you will be losing less and less money. Sophisticated stock Option traders use multiple Options contracts and buy each one, as and when the market makes a move. Simply put, you can be less accurate about the market and still make money, in scenarios where all other trading vehicles would have failed!
