This article looks at the potential advantages and disadvantages of using options. Understanding these are crucial for investors and present a factor to investors in formulating their option trading strategies.
What are the Advantages?
Options contracts provide a number of potential advantages to holders and writers:
Advantages for holders
o Protection
Call options give those investors wishing to protect their existing positions a way to ensure that their underlying assets (e.g. stock) can be sold at a certain price within a given time frame.
Furthermore, put options potentially give investors a means of speculating whilst simultaneously limiting their losses: in terms of say an option to buy stock, the holder’s highest potential loss would be the price of the option (which would be realised in the case that he/she does not exercise the option); by contrast, were the investor to invest directly in the same stock, his/her potential loss would be the total value of the stock (e.g. if the stock became worthless).
In addition, as options impose a fixed obligation on writers independent of market changes, it also create the potential for those correctly positioned to generate profits even when the market is falling.
o Leverage
Furthermore, as holders of put options, investors can potentially get “more bang for their bucks” (i.e. higher returns on their investments (ROI)) by controlling more equity with their money than would be the case if they were to purchase the relevant underlying assets outright.
Advantages for writers
Options also offer some potential advantages to writers. For example, in a “covered call” (i.e. where the option writer owns the property that is the subject of the option), the options premium in respect of that property can represent an additional source of income for the writer (without the writer having to dispose of that property) if the option expires before being exercised
General advantages
In addition, the current market offers all investors, whether they wish to be holders or writers, with a wide range of option contract models of varying complexity.
What are the Disadvantages?
There are several potential disadvantages which investors should bear in mind while designing their option trading strategies.
For example, unused options are worthless once they have expired. Hence, if it has not been exercised prior to its expiration date, the holder will have effectively wasted the premium.
Furthermore, as noted above, options can be extremely complex and can require a good deal of market observation in order to be used effectively.
Tips for new investors
- Novice investors thinking of becoming holders should first consider their own risk profiles: they should decide whether they wish to use options to leverage their existing capital, or to protect them against unwanted near-term market fluctuations (as above).
- Investors should also factor in brokerage fees when considering the cost of options contracts. Indeed, the cost may be higher on a percentage basis than the cost of trading in the underlying stock.
- Furthermore, there are a number of strategies available to investors, some more high risk than others. The novice investor would be best off avoiding the high risk end of the spectrum (e.g. becoming a writer on an uncovered call, i.e. where the writer grants an option over property that he or she does not own – there is no theoretical limit on the losses that the writer may incur under such an arrangement).
- All investors should understand the potential for options contracts to generate losses (e.g. where the size of the premium negates the profits made from the acquisition or disposal of the underlying asset).
- Lastly, it may be more advisable for beginners seeking to make money trading stock options to initially only enter into options contracts as holders, rather than writers (owing to the greater potential risks facing writers).
The information presented in this article is by no means complete. Of course, there are many more factors one needs to consider in formulating effective option trading strategies before diving into this potentially lucrative venture and certainly, one would be well advised to fully understand the pitfalls beforehand.
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