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A Quick Look at Options Trading: 3 Benefits & 4 Cons

By Chika

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Last Updated: April 11, 2022

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Trading stock options is more complicated than trading stocks.

When you purchase a stock, you just specify the number of shares you desire, and your broker fills the order at the current market price or a limit price you choose.

Options trading necessitates an awareness of sophisticated tactics, and creating an options trading account entails a few more procedures than opening a standard investing account.

 

What is Options Trading?

An option is a contract that grants the investor the right (or option) but not the responsibility to purchase or sell a certain stock or ETF at a predetermined price (known as strike price) for a predetermined period of time, which can range from days to years.

When the stated time period expires, the option loses its value and ceases to exist.

Unlike shares of stock, an option does not represent ownership in the underlying company. Options are derivatives—that is, they aren’t really assets. Rather their value is derived from the underlying asset.

Furthermore, whereas a stock investment may frequently be retained for an extended length of time, all options eventually expire. Options often lose value as their expiration date approaches and might become worthless.

Market volatility approaching expiry can also increase an investor's risk that an option will be worthless when it expires.

 

 

Two Types of Options Trading

Options can be traded in either of two ways - Calls and Puts. Let's have a look at them. 

Call options

These give the holder (buyer) the right to buy a specified number of shares (usually 100) of a stock or ETF at the strike price, at any time until the contract expires. Calls are bought when a trader thinks the price of a stock will go up. 

Put options

These give the holder the right to sell a specified number of shares of a stock or ETF at the strike price, at any time until the contract expires. If an investor purchases a put option on a stock, they are invariably betting that the stock's price will go down. 

 

 

3 Benefits of Options Trading 

Cost-Efficiency

Options have great leveraging power. As such, an investor can obtain an option position similar to a stock position, but at a far lesser cost.

For example, to purchase 200 shares of an $80 stock, an investor must pay out $16,000. However, if the a trader were to purchase two $20 calls (with each contract representing 100 shares), the total outlay would be only $4,000 (2 contracts x 100 shares/contract x $20 market price) thereby saving $12,000. 

Higher Potential Returns

Options offer potentially higher returns than stocks, and within a shorter time frame too. 

Offer alternatives

Options offer more strategic alternatives for traders thereby providing them a very flexible tool. Options can be used to recreate other positions (synthetic position), or hedge existing positions to reduce risk.

 

4 Cons of Options Trading

Time decay

The most significant disadvantage of options trading is time, because as the option approaches its expiration date, its value diminishes. A stock buyer has an infinite amount of time to prove if the investment choice is right or wrong.

An options trader, on the other hand, must be in the money by the expiry date in order to earn.

Taxes

Except in extremely unusual cases, all gains are taxed as short-term capital gains. This is practically the same as regular earnings. The rates are the same as your personal income tax rates.

Because of the tax position, it's advisable for subscribers to execute option strategies in an IRA or other tax-deferred account, although this is not always practicable. 

Commissions

When compared to stock investment, fee costs for options, particularly weekly options, are exorbitant. It is not uncommon for commissions to reach 30% of the money invested over the course of a year.

Uncertainty

Leverage swings both ways. While it serves as an advantage when investors are correct, option traders can really take a big hit when wrong.

Since the price actions on underlying assets are somewhat unpredictable, coupled with the high leverage on options, this could be a disadvantage for options traders.

 

 

How Risky is Options Trading?

Options trading is notoriously dangerous, owing in part to how difficult it can be to comprehend. This is why it is critical for investors to understand how options operate before getting engaged.

Putting your money into something you don't understand is never a wise financial decision.

As an options investor, the risk you incur ultimately relies on your part in the contract (which side you're on) and your strategy, as there are various methods you may follow, utilizing different combinations of options.

The options markets offer bullish and bearish strategies, hedging and speculative trading opportunities and varying degrees of potential for risk and profit. Options strategies may be based on time value, volatility or even interest rates.

However, depending on the technique utilized, options investors might lose as little as a small prepaid portion of the premium when a transaction swings against them and seems to be about to expire out of the money, or they can face endless losses. Their initial investment plus infinitely more.

Because options methods can be risky, some brokers have tight standards and qualifying criteria that require investors to satisfy particular requirements.

There are several tools available to assist enthusiastic investors in better understanding the world of options trading. The SEC's Office of Investor Education includes a good explanation of options terminology that guides readers through a simple stock option contract quotation example.

 

 

Is Options Trading for You?

Before trading options, like with any other investing decision, you should have a clear picture of what you want to achieve. Options may play a number of roles in various portfolios, and deciding on a goal narrows the range of possible methods.

For example, one investor may want to trade options to generate extra income, while another may want to use options to hedge risks from a market downturn. These are two different objectives that require two different options strategies to reach their goals.

 

Bottom line on Options Trading

With a better understanding of what options are, their two varieties (calls and puts), and their risk level, you should be able to decide if they're good for you.

While you may be ready to hop on the options bandwagon, the most essential takeaway is that you understand what you're getting yourself into ahead of time.

Photo by Kanchanara on Unsplash

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