Finance - Infowire

by: Daniel Webb

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 provide those investors hoping to guard their current positions a means to guarantee that their underlying assets (e.g. stock) can be sold at a certain price within a given 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 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.

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 managing further equity with their funds than would be the case if they were to acquire the important essential assets outright.

Benefits for writers

Options also offer some potential advantages to writers. For instance, 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

Also, the present market bid all investors, whether they hope to be holders or writers, with a broad collection of option contract models of varying complexity.

What are the Cons?

There are several potential disadvantages which investors should bear in mind while designing their option trading strategies.

For instance, unused options are of no value once they have expired. Hence, if it has not been exercised prior to its expiration date, the holder will have effectively wasted the premium.

Also, as noted above, options can be very multifaceted and can entail a good deal of market observation in order to be used efficiently.

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 must also consider brokerage fees when taking into account the cost of options contracts. Undeniably, the cost may be higher on a percentage basis than the cost of trading in the essential stock.

In addition there are a lot of approaches accessible to investors, some are more risky than others. The neophyte investor would be best off staying away from 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 possess – there is no hypothetical boundary on the losses that the writer may get 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 offered in this article is absolutely not 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.

Visit my blog on more information about how you can make money trading options and grab some free ebooks and e-courses along the way: http://www.savvyfinancialtraders.com