Both novice and seasoned traders often have many questions in their quest to understand options trading. In this article, we will discuss some of the more frequently asked questions.
How Are Options Better Than Other Derivatives?
Options, like other derivatives, are highly leveraged financial instruments. This means that for a much smaller outlay, you can receive the same rewards that would normally accrue for a much larger sum invested. You can receive more than ten times the profit from an option trade as you would if you had invested the same amount of money on buying the shares themselves.
But options are not the only derivative that allows this kind of leverage. You can do the same thing with futures or ‘contracts for difference’ (CFDs). Both these arrangements involve a small deposit to take on the potential risks and rewards for price movements that would normally accrue if you had purchased or sold the entire amount specified in the contract. In the case of CFDs, the remaining amount above the deposit (often as low as 5 percent) is financed by the market maker in exchange for interest debited to your account. You can realize a princely sum if the share or commodity price moves in the anticipated direction.
But if it goes the opposite way to your expectations, you learn what the ugly side of leverage looks like. The same profits you could’ve made become the exact amount of losses you now suffer. If it is more than your entire trading capital, your broker will call you and ask for more funds, which you are legally obliged to pay.
Leverage working against you without limits can quickly bring financial ruin.
Options on the other hand, involve limited risk. As long as your positions are only bought ones, the most you can ever lose is the amount you have invested on any one trade. It can never be more than that. Selling options ‘naked’ is never recommended. But you don’t need to short sell options to profit from either a rising of falling market. You simply buy either call or put options depending on anticipated direction.
So in summary, options are preferable to other leveraged instruments in that the level of risk is limited to your investment.
So What is the Downside?
Unlike CFDs, but not unlike futures, options have a limited life. All option contracts have an expiry date – and as that date draws closer, the value of ‘out-of-the-money’ options declines at an exponential rate, particularly during the final 30 days.
This means that you can’t hold your positions forever in the hope that one day, you will make some leveraged profits from the deal. You can of course, extend the time needed to be right by purchasing long dated options with many months, even years, to expiry date. But you pay more for the privilege of time. You can however, reduce the effect of this by entering debit spread positions instead of simply buying a single option. It is usually recommended that vertical debit spreads have at least 90 days until expiry date – it gives you enough time to be right.
What Else Can Options Be Used For?
Options can also be used to hedge existing positions or to make more profit from existing investments. If you already own shares, or wish to purchase them, you can also write (sell) call options at exercise (strike) prices above your share purchase price and make extra income selling covered calls – or in effect, reduce the original purchase price of your shares.
Hedging is a process whereby you spend a small amount of money to create a position that will make sufficient profit or loss, to offset the effect of price movements in your asset portfolio, which cost you a much larger sum. The leverage available in options is what gives you this power.
What Else Can You Do With Options?
Once you understand the concept of leverage and combine that with a knowledge of how option pricing works, you can actually place ‘non-directional’ trades. You can take a position both ways. You don’t care which way the future price movement goes, as long as it goes somewhere. With setups such as straddles and strangles, you can realize such a profit on the winning trade that it pays for the losing one and them some. There are certain setups you need to look for, but when you find them, straddle trades can be a very safe and highly profitable strategy.
On the other hand, you may not want the underlying stock to go anywhere in the near future. There are other option trading strategies that are tailored for this expectation.
In summary, the beauty of options trading is that, unlike most other derivatives, they are so flexible in what you can do with them.
Understanding option trading means becoming acquainted with the all the option trading basics and advanced option trading strategies. So begin your exciting journey of discovery and self education. Empower yourself to become financially self sufficient.
