What Are Options?
Options are contracts that allow an investor the option to purchase or sell stock at a particular price anytime before it expires.
An option contract generally covers 100 shares of the company; so, if you buy the right to buy Apple stock at a certain price, it is for 100 shares of the company.
Keep in mind that these contracts are distinct from the stock options employees may receive from their respective employers.
Call Options
If you buy a call option, you’re buying the right to purchase at a certain price (the strike price) by a preset expiration date, although there is no obligation to do so.
When you sell a call option, you are agreeing to sell the stock at that price if the buyer assigns (or takes up) their option.
Put Options
Put options are a type of financial instrument that give the buyer the right, but not the obligation, to sell a stock at a specific price within a set timeframe.
Pros Of Options Trading
Options have the following advantages to a trader:
Limited Downside (For Buyers)
An option buyer can only lose the value of the bought premium (unlike sellers – see below).
(However, this is unlike owning stock where losing everything is rare).
Smaller Commitment
Options allow you to benefit from stock price movements without having to buy actual shares. Consequently, your potential returns could be much higher compared to what you initially put in. If things don’t go your way, you’re only out the contract premium.
Flexible strategies
Many more investment strategy can be achieved trading options than with stocks.
Depending on the type of option and whether you are the buyer or seller, options can be used to protect existing investments, provide supplemental income from existing stocks, or meet other investment objectives.
For example of you’re bullish about a stock – you expect it to rise – you can use a long call or bull call spread to take advantage of any increase in stock price.
Similarly bears can trade long puts or bear put spreads.
Options can even be used if you believe a stock won’t move much: options trading strategies such as calendar spreads and iron condors be traded profitably.
Cons Of Options Trading
However options do have several disadvantages
Complexity:
You must comprehend the technical language and regulations associated with options.
Therefore, it would be advisable to stay away from them until after you have obtained a decent amount of expertise in the stock market and have studied their operation.
Options sellers’ risk is potentially unlimited
For example the seller of a call option with a $200 strike price is obliged to sell shares at this price at any time during the option’s life.
But the share could potentially rise to any price forcing a trader to buy at this price but sell for the $200. The potential loss is therefore (in theory) infinite (although this can be mitigated by proper risk management).
Low Liquidity
Lower liquidity of some stock options can be a major challenge for traders looking to enter and exit the trade market.
Options Margin requirements can run up trading costs
One of the biggest costs associated with options trading is margin requirements, the amount of money that must be deposited with your brokerage in order to open an options position.
The amount of margin required depends on the type of option being traded, as well as the underlying security.
Commission Costs
Options trading costs more expensive as compared to future or stock trading, especially with a full-service brokerage.
You may be able to reduce these costs using discount brokers such as Robinhood to trade on lower commissions.
Bottom Line
When analyzing the pros and cons of option trading, there are many factors to consider.
The safety net of defining your downside allows you to speculate on short-term price movements while still preserving all of the upside. Moreover, buying options has a positive skew. In statistical terms, this means you’ll lose a small amount of money most of the time and make a large amount of money some of the time.
The trade-off is extremely beneficial because you only need a small number of trades to pay off to have a profitable month or year.
About the Author: Chris Young has a mathematics degree and 18 years finance experience. Chris is British by background but has worked in the US and lately in Australia. His interest in options was first aroused by the ‘Trading Options’ section of the Financial Times (of London). He decided to bring this knowledge to a wider audience and founded Epsilon Options in 2012.
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