Pros and cons of options
Using options as part of your portfolio has several advantages and disadvantages.
Some of the pros include:
- Easy access to leverage: When you buy an options contract, you only have to pay a fraction of the value of the shares in order to gain exposure to a stock. That can allow you to generate significant gains on a small investment. On the other hand, it could produce big losses.
- A good hedge: Options can be used in conjunction with stock holdings to hedge a position or produce additional income. For example, you could write a call option to generate income on a holding now, but the upside potential is limited. Likewise, you could buy a put option to protect against downside risk.
- The ability to buy stock at a lower price: You can sell put contracts in order to get paid while you wait for a stock to reach your target buy price. This can help generate income on the cash sitting on the sidelines waiting for a buying opportunity.
Some of the cons include:
- Expiration: Options will eventually expire, which means that you have a limited time for your investment thesis to pan out. So, not only do you have to be right, you have to be right right now.
- Time value decay: Since options expire, part of their value is determined by how long they have until expiration. As they get closer to expiration, that value decays. Some options will expire worthless as a result.
- Short-term gains: More often than not, the gains made on an options trade will be short-term. As such, you’ll have to pay taxes on the gains at your regular income tax rate instead of the preferred long-term capital gains tax rate.
What are stocks?
Stocks, also known as equities, are a type of security that represents a proportional ownership stake in a company. If a company issues one million shares of stock and you buy one share, then you own one-millionth of that company.
Buying and holding stocks is the easiest and most straightforward way to invest.
Pros and cons of stocks
Buying and selling stocks has its own set of benefits and drawbacks.
The pros include:
- Dividends: As a shareholder, you’ll receive dividends from any company that pays them. If you gain exposure to the stock through a derivative such as an options contract, you won’t receive any dividends.
- Indefinite holding period: There’s typically no limit to how long you can hold your shares. As long as a business is operating as a publicly traded company, you can keep your shares. That means you have plenty of time for your investment thesis to play out. It also means you can easily hold for a year or longer and only pay the long-term capital gains tax rate on any gains.
- Low cost of entry: Many brokers will allow you to buy fractional shares of stock for as little as $1 or $5. Despite the leverage provided by options, you’ll usually have to invest a lot more since they’re sold in units of 100.
The cons include:
- Limited leverage: Trading stocks with leverage isn’t a great strategy, but most brokers won’t provide you with much margin to begin with. The typical broker will only loan up to 50% of your stock purchase price.