Modern investors and traders have more markets and vehicles to trade than ever before. Although each trading vehicle has its pros and cons, there are few that provide the flexibility of options.
An option contract simply gives the holder the right, but not the obligation, to be long or short the underlying contract at a certain price at a specific date in the future. Options can have several advantages over other trading vehicles and may be used by investors to accomplish a variety of objectives. Outlined below are three of the biggest potential advantages of options trading:
An option contract on a stock controls the right to buy or sell 100 shares at a certain price at a specific date. To purchase an option, the investor pays a premium to the option seller. This premium is often significantly less than what it may cost the investor to buy or sell 100 shares of actual stock. For example, if stock ABC is trading at $50, an investor may have to shell out $5000 to purchase 100 shares. A two-month option on the stock, on the other hand, may only cost $1500. The investor can then control the same amount of stock using less capital. The capital saved may then be used for other investments.
2. Defined Risk
If an investor purchases an option, the risk of the purchase is limited to the premium paid. For example, if an investor purchases a call option for $500, then the maximum risk of the position is $500. The stock price could go to zero and the investor still cannot lose more than the $500 paid.
Option spreads can also be sold with defined risk. For an investor looking to collect time premium, the sale of a short option combined with the purchase of a long option brings in a net credit while keeping risk defined to a certain amount. The amount of risk associated with a short spread will depend on the size of the spread and the net premium collected.
3. Unlimited Profit Potential
A long option position may have unlimited profit potential. A call option purchased on a stock, for example, can theoretically keep going higher as long as the stock price keeps rising. The lack of a profit ceiling on this type of position makes them extremely attractive.
Profit on Volatility
An option trade can potentially profit not only from directional moves in the market but also from changes in implied volatility. If an investor just buys shares of stock with no dividend, the only way to profit from the stock is the price going up. A long call option on the stock, however, may potentially profit even if the stock price does not rise. Changes in implied volatility, or what an investor is willing to pay for an option, can fuel significant price fluctuations.
Profit on Time Decay
An option is a wasting asset. Every option bought or sold has an expiration date. If the option has no intrinsic value at that point, it simply expires worthless. The time decay aspect of options can be a significant hurdle for option buyers while providing a significant advantage to the option seller. If all other inputs stay constant, an option will lose value every day until it expires. This can provide option sellers with a way to potentially profit even in sideways markets or low volatility environments.
Options can provide an invaluable tool for both expert and novice investors. Although options may seem complicated at first glance, they can be used by anyone. There is a wealth of information available for those looking to trade options. A guide to options trading is a great place to start and can provide traders and investors with the basic knowledge necessary to use options.
Options can provide a great deal of flexibility. Although these contracts can potentially provide unlimited profit potential, they also come with risks. Naked option selling, for example, carries with it unlimited risk and is not suitable for all investors.
Options can be a powerful tool in a trader’s arsenal. Given their numerous potential advantages, modern stock investors may want to consider incorporating these powerful trading vehicles into their overall strategy.
Shift Frequency © 2019 – Three Advantages of Options Trading