Why Trade Options
Advantages and Disadvantages
There are many ways to make money in the world of investment. So why trade options?
Option is one of the most versatile trading instruments available.
They can be traded on a variety of underlying instruments such as stocks, stock indexes, currencies, futures, exchange traded fund, commodities and bonds.
The wonderful thing is that options of all these instruments function in the same way. So once you had understood stock option investing, you will be able to trade options in these underlying instruments.
Options are versatile as they can be used for a variety of reasons than simply buying/selling stocks. In fact, depending on your trading goals and styles, it may be a better trading vehicle for you than owing a stock.
Advantages of options
1. Leverage
The main advantages of trading stock options than simple stock is the leverage involved. Options enable you to control the shares of a specific stock without tying a large amount of capital in your trading account. The amount of capital (premium) that you are paying is a relatively small amount comparing to the cost of buying the same amount of stocks.
The capability to invest a smaller amount of capital and control the stock give the option trader the flexibility to
- Trade higher-priced stocks, the big movers, that are normally out of reach to the smaller account traders.
- Magnify profit when the stock moves in your favor.
- Make money based on a relatively small movement in the stock.
2. Passive Income
Certain income producing option strategies enable you to generate a monthly passive source of income. One of the most widely used strategies to generate passive income is to write “Covered Calls”. Traders who deploy this strategy is acting similarly to a landlord who bought a house (stock) and earn rental income (premium) by renting (write Covered Calls) the house (stock) to another person. One key point to take note over this simplified example is that the trader who wrote the Covered Calls may be forced to sell his stock when the options is exercised. So be sure to deploy this strategy only if you are willing to depart with the stock that you own.
3. Profit from bull, bear and side way market
There are various options strategies that give the options trader the ability to make money from all market directions (up, down or sideway market) with limited risk exposure and potentially unlimited profit. A few examples are, buying call options when the market is bullish, buying put options when the market is bearish and entering into various credit spread strategies to earn profit when the market is range bound.
4. Hedging against risk
Stock options can be used as an instrument to hedge against various risk exposure of a stock holder. For example, if you are a holder of 1,000 shares of IBM and suspect that the stock price might drop, instead of selling the shares to stay away from the uncertain future, you can simply buy 10 put options to protect your current position. It can be an inexpensive insurance to protect your stock portfolio from any adverse move in the market.
Disadvantages of options
1. Time value decay
Unlike stock where you can hold on to it for many years or even passes on to your children, all options have an expiration date. Remembering that options is a “wasting” asset, there is nothing you can do to stop the options from expiring. The rate of time value decay increased over time when the options get closer to the expiration dates. Therefore be sure to watch over your open options position like a hawk and not to let it expired worthless.
2. Full Loss of Investment
If you hold onto a trade that go against you and the options are out of money at expiration date, you may lost every single cents that you invested in the options.
3. Leverage
If you feel that losing every single cents of your investment is bad, wait till you are aware that you can possibly lost every single cents of what you have by writing naked options that goes against you.
The same reason leverage can help you earn profit in shorter time frame can break your account in half (or faster) time just as quickly.
The reward and danger of leverage is especially powerfully when you are selling naked calls or puts or entering into any unlimited risk option strategies.
Options trading is a highly speculative venture and it has substantial risk & reward involved. Have a through understanding on why you trade options. Remember there is nothing wrong if you hear yourself saying, “Yes! I can do it too!” Or another voice telling you,” This is too risky! Too complicated and do I need to get myself involve in something so speculative?” Trust your gut feeling and do what you feel is the best for you.
Next go to Options Expiration Dates to understand the fundamental of option basics
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