Traders choose options over stocks for their versatility and limited risk, but there are certain drawbacks as well. These three considerations are crucial when choosing which vehicle to buy or sell.

Traders face many hard decisions every day: Buy or sell, add or lighten, stand aside or get involved. Among them is the choice between trading options or common stock.

There are no doubt certain benefits and shortcomings of both choices, as everything literally is a tradeoff.

Common stock is usually much more liquid, it can be traded in the after hours or premarket, and it’s by definition 100% exposure to the company. However, it is more capital intensive since it’s not a leveraged position, which means less room for other positions in an account. Common stock alone is also going to carry with it greater dollar risk, as a major headline can bring tremendous gap trading potential.

Options are leveraged, they offer lots of versatility and possibilities (speculation, hedging, income, etc.), and they are less capital intensive. However, liquidity is often inferior compared to common stock, options can’t be traded as many hours of the day as stocks can, and options offer only fractional exposure to the underlying stock.

The Case for Options

Options can be an excellent vehicle for trading, however, provided the situation is well-suited to them. The three biggest considerations for options traders are:

  1. Time frame for the trade;
  2. Liquidity of the options being traded, and;
  3. Risk involved in the trade

Let’s break each of these factors down in greater detail.

Time Frame

First things first: The time you expect to be in the play is important because options will carry a bid/ask spread often times up to 10-15 cents. For a stock, that’s not a huge deal, but for an option, which might only be trading a $2 or lower, that’s a big percentage if you pay the spread both ways (market order getting in and getting out).

So if you’re looking at being in a trade for at least a couple days, that’s usually much better for an options trade than if you’re just looking to scalp it over the next half hour.

NEXT: Liquidity, Risk, and Specific Times to Choose Options Over Stocks

Liquidity

Second, there are quite a few stocks that have high trading volume, but for whatever reason, their options are just not heavily traded. For any trade I take, be it for a stock or an option, I want to feel confident there will be buyers when I go to sell, and sellers when I go to buy. Sufficient liquidity is a requirement for any trade, whether in options or common stock.

So taking a look at the open interest, the volume, and the bid/ask spread is important for gauging the liquidity of the options.

When in doubt, take a look at the highly liquid options on the PowerShares QQQ Trust (QQQ), or the S&P 500 (SPY), or mega-cap stocks like Microsoft, Inc. (MSFT) or Intel (INTC). That will help you get a feel for how tight the market is in the options you’re considering. You don’t ever want to be the “big player” in any contract.

Risk

Third, limited risk is an advantage that options carry, such as buying put options versus being short stock. Risk is defined with the puts, and is theoretically unlimited with the short stock. Options are a great choice in particular when the stock has the potential to gap big, whether due to news coming out or simply based upon recent price history of the stock.

Always consider the risk involved when weighing options versus common stock, as that’s an important element of the decision making process.

Finally, here are a few specific occasions to opt for options over the common shares:

  1. In front of big news (earnings, conference calls, or anything else scheduled)
  2. When limited on capital (the leverage of options helps offset a limited amount of funds)
  3. When the stock moves are too shaky to sit through (when a really wide stop is necessary)
  4. When your trading time frame is between a couple days and a few weeks

By Jeff White, trader and educator, TheStockBandit.com

Related Articles
  1. Budgeting

    Trunk Club Review: Is It Worth It?

    Take a close look at one of the best-known online clothing services in the country, and determine whether it's a good fit for your style and budget.
  2. Budgeting

    HelloFresh Review: Is It Worth It?

    Discover one of the world's most successful meal subscription services, and learn more about how the service operates and what it costs.
  3. Stock Analysis

    Starbucks: Profiting One Cup at a Time (SBUX)

    Starbucks is everywhere. But is it a worthwhile business? Ask the shareholders who've made it one of the world's most successful companies.
  4. Stock Analysis

    How Medtronic Makes Money (MDT)

    Here's the story of an American medical device firm that covers almost every segment in medicine and recently moved to Ireland to pay less in taxes.
  5. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  6. Budgeting

    Just the Right Book Review: Is It Worth It?

    Take an in-depth look at Just the Right Book, a subscription service that delivers personalized book selections based on your reading history and preferences.
  7. Investing News

    Stocks with Big Dividend Yields: 'It's a Trap!'

    Should you seek high yielding-dividend stocks in the current investment environment?
  8. Investing News

    Should You Be Betting with Buffett Right Now?

    Following Warren Buffett's stock picks has historically been a good strategy. Is considering his biggest holdings in 2016 a good idea?
  9. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  10. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
RELATED FAQS
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Can mutual fund expense ratios be negative?

    Mutual fund expense ratios cannot be negative. An expense ratio is the sum total of all fees charged by an asset management ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center