Options Trading – Advantages and Disadvantages
What is Options Trading?
An option is simply granting someone the right to buy or sell something in the future. In the case of Dow index futures options, when someone buys a Dow call option they are buying the right to purchase that underlying Dow future at a specific price, known as the “strike price,” at a future point in time, known as the “expiration date.” When an investor buys a put, they are essentially selling the market; a call essentially buys the market. Likewise, selling a put essentially buys the market; selling a call essentially sells the market.
In order to receive the opportunity to buy an option on this future, investors pay a “premium.” If the market does not reach the strike price of the option, then that option will expire worthless on the expiration date. If the market does reach the strike price of the option on the expiration date, then the investor will be assigned the underlying future at that strike price.
Advantages of Options Trading
Flexibility. Options can be used in a wide variety of strategies, from conservative to high-risk, and can be tailored to more expectations than simply “the stock will go up” or “the stock will go down.”
Leverage. An investor can gain leverage in a stock without committing to a trade.
Limited Risk. Risk is limited to the option premium (except when writing options for a security that is not already owned).
Hedging. Options allow investors to protect their positions against price fluctuations when it is not desirable to alter the underlying positon.
Disadvantages of Options Trading
Costs. The costs of trading options (including both commissions and the bid/ask spread) is significantly higher on a percentage basis than trading the underlying stock, and these costs can drastically eat into any profits.
Liquidity. With the vast array of different strike prices available, some will suffer from very low liquidity making trading difficult.
Complexity. Options are very complex and require a great deal of observation and maintenance.
Time decay. The time-sensitive nature of options leads to the result that most options expire worthless. This only applies to those traders that purchase options – those selling collect the premium but with:
Unlimited Risk. Some option positions, such as writing uncovered options, are accompanied by unlimited risk.
Overall Options present a good opportunity to formulate plans which can take advantage of volatility in underlying markets as well as price direction. However for most traders the disadvantages are significant and online futures trading is usually a better option.
Article Writer: Tim Wreford