Identifying the Pros and Cons of Options to Ensure an Effective Option Trading Strategies

by: Daniel Webb

This article looks at the potential advantages and disadvantages of using options. Considering these are vital for investors and present an aspect to investors in inventing their option trading strategies.

What are the Benefits?

Options contracts present a lot of potential advantages to holders and writers:

Advantages for holders

o Protection

Call options provide those investors hoping to guard their current positions a means to guarantee that their underlying assets (e.g. stock) can be put up for sale at a definite price within a specified time frame.

What’s more, put options potentially offer investors a way of considering at the same time as concurrently preventing their losses: in terms of say an option to purchase stock, the holder’s maximum potential loss would be the cost of the option (which would be realized in the case that he/she does not use the option); by contrast, were the investor to invest directly in the same stock, his/her probable loss would be the whole price of the stock (e.g. if the stock became of no value).

Additionally, as options entail a permanent responsibility on writers independent of market changes, it also form the probability for those properly positioned to produce earnings even when the market is declining.

Power

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 instance, in a “covered call” (i.e. where the option writer is the owner of the property that is the subject of the option), the options premium with regards to that property can stand for an added source of income for the writer (without the writer having to dispose of that property) if the option expires before being executed

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.

Advise 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. Undeniably, the cost may be higher on a percentage basis than the cost of trading in the essential 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 must know the likelihood for options contracts to produce losses (e.g. where the size of the premium negates the profits made from the acquisition or disposal of the underlying asset).

Finally, it is much sensible for newbies who are looking to make money through stock options trading to primarily go into options contracts as holders, rather than writers (due to the larger possible risks facing writers).

The information presented in this article is by no means complete. Naturally, there are a lot more aspects one should think about in putting together effective option trading strategies prior to pitching into this potentially profitable venture and definitely, one would be sensible to completely comprehend the consequence beforehand.

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