Options trading are a good way for any investor to manage risk. Basically, an option allows an investor to buy or sell shares from stock in a given contract at a predetermined price by a given date. Options allow the trader to guess the direction the price of a stock will go without buying. Instead, as an options trader, the investor can;
- Buy or sell shares at a given price for a specified period
- Sell the contract to another trader.
- Allow the options contract to expire at which the investment is lost with no profits.
Buying Options
Buying options is done in the same way as buying stock where the investor takes a long term position on an option with the expectation that the price will go up. The investor picks the options they want and place an order to buy with an options broker.
When the options increase in value, the investor can either sell them or use the option depending on their interests. If an investor expects the underlying asset to decrease its value, then they can buy a put option which allows the trader right to sell it at a fixed price. The investor can also close short term positions opened by buying them off to finish the deal with the broker.
Selling Options
An investor can sell options by selling to close the order or by opening a short term position and selling them which is called writing. The writing option allows the trader to write new contracts and sell them in the same market.
Advantages of Using Options Trading
Limited Losses
Option buyers mostly lose the amount they invest and nothing more. This is unlike other trading options such as spreads where losses are unlimited since stops are not used making losses substantial to the trader. The leverage is also high for options traders meaning that if their bet is correct and the underlying asset appreciates in value the option traded moves in their favor.
High Buyer Control
The investor as the buyer gains high leverage in the options which guards the investor against volatile market price movements.
Profits with Limited Money
Options allow investors to make huge profits without investing large amounts of money. This means that investors with little money can trade along with those with larger capital. With the high leverage, investors get high exchange power small investors can gain high profits.
Low Risk & High Reward
Investors can gain better risks with options trading when the option is traded correctly. The investor also gets to choose the level of risk to take before trading. With so many options and orders to choose from, investors can limit their risk as opposed to buying and selling stocks.
Flexibility
Options are also a flexible investment with limited trading strategies. Options allow the investor to buy and sell based on many underlying assets while speculating on the price of stocks without committing especially for foreign currencies. With speculation the investor is flexible to make decisions on possibly profitable assets.
Disadvantages of Options Trading
Hard to Understand
Trading in options requires the investor to muster everything about it since it is not straightforward as other trading ideas are. Learning more about options trading is one way for investors to benefit from this form of investment.
High Risks
This is true for investors who have limited understanding of options trading. Options are mainly used to limit risks but only for those who understand how to use them to their benefit. Understanding the risks is one way to go about mitigating them.
Risks in Options Trading
Liquidity
With so many trading options, a single option may be traded in low a volume which is a risk to investors. This is because it makes it difficult to trade at the correct prices. Although liquidity issues are controllable, there is still risk that investors need to understand before trading options.
Costs
Knowing the types of options available and the prices involved helps avoid this risk. Understanding the spread which is, the difference between ask and bid prices. The bigger the spread the higher the costs and with no liquidity the investor incurs higher spreads.
Time Decline
Options have a time value which means that they expire at a given date. This is an unavoidable risk but the longer it takes to expire the longer their time value. Options are constantly losing time value which can affect their value though this does not mean the value declines.