There are two ways to build up a profitable stock portfolio. One way involves unlimited downside risk and the other involves limited upside risk. Today we are going to assume you are interested in purchasing individual stocks. (Please remember that this is not investing advice, continue to the full disclosure for posts regarding investing.)
There are other ways to create a diversified portfolio including mutual funds, ETFs and other asset classes, but today we are focusing on individual stocks versus stock options. See more of the Battle Royale series with mutual funds vs ETFs and common stock vs preferred stock.
Stock Options vs. Individual Stock
BATTLE ROYALE!
Potential Loss
Like I mentioned earlier, there is unlimited potential downside risk in one of the methods to building a profitable stock portfolio. Purchasing individual stocks is pretty risky when you look at it in terms of potential loss. If you go long a stock, and the company goes out of business, or share value goes to zero, you are out your entire investment. If you decide to go short, or sell a stock you do not own, the potential loss is unlimited! As long as the price of that stock continues to rise, you are continually losing money.
With stock options you can limit your risk. Instead of going long the stock, you could purchase call options. The buyer of a call option has the right to purchase a fixed number of shares at a set price. Your risk, while you held the call option, would be limited to the premium you paid to have that option. If the stock price drops while you are holding that option, you do not participate in any lost income.
Conversely, instead of shorting the stock, you could purchase a put option. The buyer of a put option has the right to sell a fixed number of shares at a set price. If the stock price shoots through the roof while you are holding that put option, you do not participate in that loss, your loss would be limited to the premium you paid to hold the put option.
Winner: Stock Options, for their ability to build a portfolio at the price you choose.
Portfolio Hedging
A portfolio hedge is protection against expected risk. For example, if you know that when the market tanks, gold typically rises, you would set up your portfolio to protect your self against losing everything by mixing stocks with gold. Or, to use gold as an example again, if you knew that when inflation rises, the price of gold rises, you might buy gold as an inflation hedge. Although, a bit of an advanced topic, hedging a portfolio is not very difficult once you understand the method behind it.
With that said there are two ways to hedge your portfolio with either stocks or options.
With stocks, you can buy stocks that have low correlations. That way when one stock goes up, the other might go down. An easy way to do this is to look at the beta of a stock. A stock with a beta of 2 is expected to go up when the market goes up, just at a faster rate. A stock with a beta of -2 is expected to down when the market goes up, just at a faster rate. A simpler way to hedge your portfolio is to diversify.
With options you can also hedge your portfolio. Some investors sell puts on their long stock position which can help them lock in a particular price point to sell the stock if it declines. Some investors buy puts on their long stock portfolio at the desired sell price and sell calls at the same time to lock in a desired sell price range. This is a hedge strategy that combine calls and puts for more advanced option plays.
Winner: Stocks, for the simplicity of portfolio hedging
Income
Stocks offer dividends and potential capital appreciation, meaning the price could go up. Dividends are paid annually or semi-annually with several paying quarterly or even monthly.
With options, you can integrate a covered call strategy into your portfolio. If you own at least 100 shares of a stock, you can give someone else the option to buy your shares at a set price. If they decide to buy the shares, you are obligated to sell at that set price that you agreed on, but for making that agreement you receive a payment. There is a chance that the option holder will not want to buy the shares, especially if the agreed upon price is now too high, and you will get to keep the payment, or premium that they had to pay.
This is a simple strategy that is usually recommended for beginner option traders, in fact it is the first level of approval that a broker will give you. (Your broker has to approve you to buy and sell calls depending on their assessment of your risk tolerance.)
Because most stock options expire worthless, it is highly likely that you will not actually have to sell your stock. If you implement this strategy each month, you will essentially have created a dividend for your self.
Winner: Stock Options for the ability to earn dividends and covered call income.
The winner of the Battle Royale is the Stock Option!
Stock options can be a great way to build your portfolio. But you should ask your financial advisor for advice.
Do you agree with the winner?
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