Over the past year, the rise in retail investors trading options has exploded. You only have to look at the sad news of the death of a 20-year-old in America recently who wrongly interpreted his option trade position to understand how serious it can be. Trading options have a time and a place and I’ve used them before when investing. But when looking to generate sustainable profits, I much prefer to buy FTSE 100 growth stocks outright instead.
What’s stock option trading?
An option is similar to an insurance contract. You pay an upfront premium for the right to be able to buy a stock (a call option) at a particular price, at a point of time in the future. For example, say you think the HSBC share price is going to rally from 330p. Instead of just buying the stock, you could buy a call option for £10 to give you the option to buy 100 shares at a price of 400p. If the share price goes to 500p, you get to buy at 400p and sell at 500p, netting a healthy profit. On the other side, if the share price falls to 300p, you only lose the £10 premium.
Sounds great? Well, options are complex investing products. Trading them can go badly wrong, mainly if you sell options. Imagine if you sold the above option, and made £10 upfront. You open yourself up for potentially unlimited losses, as the share price could rally to any price. Whatever profit the buyer would make, you would lose as the seller. Ultimately, for most retail investors, purely trading options isn’t really appropriate.
Why I prefer FTSE 100 growth stocks instead
Most people trade options because of the potential for large profits. I get that. But there’s also a large risk associated with options trading. With growth stocks, you’ve the ability to gain large profits, but your losses are limited to the amount you invest in the stock. For example, if I think the Ocado share price could continue on its stellar run, I could invest £1,000 into it today. I’d be safe in the knowledge that even if the firm went bust, I’d only lose my £1,000.
Secondly, actually buying a growth stock enables me to be invested for the long run. The Ocado share price has almost doubled in the past year. For those investors who spotted the opportunity early, the Ocado share price has offered returns of 550% over five years. This long-term mindset of really benefiting from a true growth stock is what investing is all about. With options trading, you’ve a set time period. You can set the expiration date of the option for a month or a year. Most options don’t have a timeline greater than one or two years. And ultimately they’re not classified as long-term investing instruments.
Stick to what you know
Options trading may sound glamorous, especially with the recent push towards it from online investing platforms. In my opinion, stick to what you know. Buying an option can be a great insurance policy on a stock you already own, but it shouldn’t be seen as a daily profit machine. Actually buying FTSE 100 growth stocks affords you the upside potential, but won’t expose you to unlimited losses.
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jonathansmith1 has no position in any of the shares mentioned. The Motley Fool UK has recommended HSBC Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.