Trading options come with several benefits over shares of stock.
The best strategy for options trading
For simplicity, this post will assume that stock investors will only purchase the S&P 500 index like SPY, and options traders sell put options on the SPY.
Make money in flat markets with options
As a stock investor, if the overall market is not moving up, then you will not be growing your wealth. As an options trader who sells puts instead of holding shares, you will make money even if the stock market does not move. The only time put selling does not work is when the market crashes. When this happens, you need to respect your stop losses.
The point is that stock investors only make money if the stock market moves up. If you sell put options, you will make money if the stock market moves up, doesn’t move at all, or comes down slightly.
Buying power efficiency
As an options trader, you can have your entire account exposed to the markets and still have more than 50% of your buying power as cash. This is because options allow you to use leverage. The best part is that you do not have to pay margin interest!
To break it down, let’s use a $100,000 account example
Let’s assume the SPY is trading at $400 per share for simplicity’s sake.
A stock investor will allocate all $100,000 into the SPY and will not have any cash left in the account. This is 250 shares.
An options trader can sell three of the 350 strike put options. This has a notional value of $105,000. However, your brokerage will only require you to use 20% of this to place this trade. You will only use $21,000 in buying power and have $79,000 cash in your account.
You can hold stocks while trading options
Since you will have so much buying power available, you can buy a small amount of SPY on top of trading options. Once you start collecting some premiums, it is excellent to allocate the profits into SPY shares. Just make sure you do not use too much leverage!
It is important to understand options in-depth so that you are aware of all the risks. Check out the best options trading books you should read here!
Advocates of long-term investing will argue that you pay fewer taxes when you hold stocks long-term. While this is true, you will get tax benefits if you trade S&P 500 index (SPX) options or futures options.
- Index and futures options are considered 1256 contracts
This means that 60% of your profits will be taxed at the long-term tax rate, while 40% will be taxed at the short-term tax rate.
Stocks vs options: stocks are still great
Even though I love to trade options, I still have a long-term stock portfolio. It does not require much management, mainly if you invest in the SPY.
Additionally, I like to invest my option profits into my long-term stock holdings. However, I believe am using the best strategy for options trading to replicate investing.