Hey, this is Sasha Evdakov and welcome to tradersfly.com, where I answer some of your frequently asked questions about trading and investing.
This week’s question is, “Is it better to trade options or stocks? What is your preference?”
First off, let’s talk about the options attraction, why are many people attracted to options? The reason why many people are drawn to options is typical because of their account size.
I find that many people who have a smaller account size are attracted to options because of leverage, so they assume that they can trade larger or use that leverage to make more and accelerate the growth process to their account.
Be cautious
You want to pay close attention to this, have some caution because it’s not always the best move to put a 16-year-old new driver inside a 500 horsepower Ferrari. And this is what people do with trading options.
They go a lot quicker and leverage things up faster than what they should be, they need first to build experience and then move into options, but many people want to jump into options because they think they can grow their account larger. Remember that you’re trading with professionals when you trade.
Pros and Cons of trading options
There are some advantages when it comes to options, for example, trading options can give you advantages like time decay, meaning you can capitalize as options decay by selling those options. You can create spread strategies that you can’t do with stocks, so you’re allowed to create a lot of different variations that you can’t do when you’re just trading stocks directionally, and finally of course leverage. There are other advantages as well, but that’s beyond the scope of this video.
There are some also disadvantages with options. Sometimes volatility and tighter liquidity in specific options can be a problem. And of course not to mention the learning curve that goes along with options, it’s just much higher, there’s much more to learn when it comes to options than there is with stocks.
However, this will give you some base guidelines when it comes to those advantages and disadvantages.
Do what works for you
What’s the final verdict? Well, it comes down to which you like better, and what works for your risk to reward tolerance, your style, and your goals.
Certain people love trucks, others like hybrid vehicles, some people love motorcycles, so I always say, do what works for you, because I’m not you, the person down the street isn’t you, and your friend isn’t you. You need to do what works for you and your style, your goal, your risk and reward strategy.
It’s one of the reasons why you don’t’ see a tennis player going into mixed martial arts right away because they are not interested in contact sports. Or a hockey player jumping into golf, it’s very rare that you see those transitions, so you need to find what works for you, for your pace and your trading style, because there’s a lot of different ways that you can trade.
What I prefer
But you still might be wondering, what is it that I like? So I’ll give you some insight.
I prefer to trade index options, like the SPY, QQQ, SPX, IWM, RUT, in my accounts because of the 1256 contract tax code. Which you can do some research on, but I’ll give you some insight here.
In my IRA accounts, I will trade any stock or option depending on preference, since you are taxed a little bit differently.
Typically those taxes are deferred towards when you take money out of those accounts or pre-taxed if you’re doing like a Roth IRA or something to that effect.
1256 contract tax code
What is this 1256 tax code and contract code?
First off, I want to make sure that you understand that this is a disclaimer, I’m not a tax advisor, so you may and should contact your accountant tax advisor, regarding your taxes and your situation, but this is just my personal Sasha’s take on the tax code, and why I like trading the way that I trade, based on some of these taxes.
One of the main advantages is this 1256 contract tax code. In this, what it states is 60% including day trades, are taxed at the lower, long-term capital gains tax rate, and 40% are taxed at the short-term rate, which is the ordinary tax rate.
With 1256 contract tax rate, you have a maximum of 28% you can use, so it’s 12% lower than the top ordinary rate, which is right around that 40% rate.
Example
Here’s an example that will start to make sense. So the current long-term capital gains tax rate is 15%, the short-term capital gains tax is 35%, if a trader makes $80,000 in profits, here’s how you’re going to be taxed if you have the 60/40 contract rule.
First off, we take 60% of $80,000 that will be $48,000. We tax that at 15% because 15% is taxed at the long-term rate, this gives us a tax fee of $7,200 that we have to pay Uncle Sam or the IRS.
Then you take 40% of that $80,000, and you get $32,000. You tax that at the short-term capital gains tax, which is 35%, and there you pay Uncle Sam, the IRS, $11,200 on your $80,000 profit.
Your total, between these two is $7,200 + $11,200. Which gives you about $18,400 on your tax bill at the end of the year, which is roughly around 23% on that tax bill.
If you did it the other way, just trading stocks, when you had $80,000, if you did day trades, swing trades, it doesn’t matter, you’re taxed at 35%, because the 100% of that is going to be taxed at 35% bracket, which will give you $28,000 on your final tax bill.
So you can see that it’s roughly $10,000 more on your tax bill, so the difference is, are you going to pay $18,400 on taxes on that $80,000? Or you’re going to pay $28,000 on your $80,000 in profits?
Of course, I’d instead make almost an extra $10,000 simply by just trading index contracts in options in my standard account, because you’re just going to make all of a sudden that much more at the end of the year, it just jumps you about another 10% in profits.
