When To Buy Stock Options Instead Of Stock
If you are a new trader and you have stock options explained to you adequately, you are probably wondering exactly when it makes sense to buy a put or call rather than simply buying the underlying stock. It’s a fair question, one whose answer we should fully grasp before attempting to wade into buying stock options.
Buying stocks simply involves taking a stake in the fortunes of a company, as represented by purchasing stock that it has issued. If we are bullish, we can buy stock in it without regard for any time frame for the move that we are anticipating.
The critical difference with stock options is that they are a decaying investment, one whose eventual expiration makes “buy and hold” an inappropriate investment philosophy. Especially if we purchase an option that is “out of the money”, we must constantly be aware of the “time decay” to which our contracts are subject. Even an “in the money” option’s value is partially made up of time value, so for any option we hold whose value is constantly decaying, we must ask ourselves much more often than if we were owners of the stock: “do I want to continue to hold this position?”
This time decay is literally part of the price that we pay to play the options game. But on the upside, the leverage that we achieve by buying options can make be extremely attractive if our expectation of a future price move turns out to be correct. Leverage like this should never be bought with a large part of our discretionary investment funds, of course. Most investment advisers would recommend investing in options with only a small percentage, certainly less than 10%, of one’s portfolio. The idea as always is to increase the overall value of one’s portfolio incrementally with options, over time, because the nature of options is that you will be wrong on some of your trades.
Even for people who understand stock or share options very well, trading them is very risky. Paper trade with options for months before buying them with real money. This is probably the best way to find out just how difficult it is to make money consistently with them.
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