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Understanding the Advantages and Disadvantages of Options for an Effective Option Trading Strategies

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:

Benefits for holders

Security

Call options give those investors wishing to protect their existing positions a way to ensure that their underlying assets (e.g. stock) can be sold at a certain price within a given time frame.

Furthermore, put options potentially give investors a means of speculating whilst simultaneously limiting their losses: in terms of say an option to buy stock, the holder’s highest potential loss would be the price of the option (which would be realised in the case that he/she does not exercise the option); by contrast, were the investor to invest directly in the same stock, his/her potential loss would be the total value 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

Moreover, as put options holders, investors can most likely acquire “more bang for their money” (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.

Benefits for writers

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

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 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.

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

Neophyte investors considering of becoming holders should primarily think about their own risk profiles: they should make a decision whether they want to use options to influence their present capital, or to keep them from 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 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 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 presented in this article is by no means 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