Option trading provides many advantages over other investment vehicles, including leverage, limited risk and insurance. However, they are not for beginner investors. It is important that you learn how they work and become familiar with different strategies before investing.
Leverage. One of largest benefits of using options is leverage. We know that options give the buyer the right, but not the obligation to buy a stock at a fixed price for specified length of time. Buying an option gives you exposure to price movement in the underlying stock at a fraction of the full purchase price of the underlying stock itself. So, for a given percentage change in the underlying price, the change in option price in percentage terms is much greater. In other words, you can enjoy the rewards of leverage, with only the predetermined and quantifiable risk of losing the premium, or the price paid for the option.
Consider this example. ABC stock is trading at €100. An investor believes ABC common stock will soon advance to €120 and decides to buy one contract of the ABC November 100 calls for a premium of €2. The cost of this transaction is just €200 plus commissions versus buying the stock outright at a cost of €10,000 plus commissions.
If the investor is correct and ABC does rally to €120 the ABC November 100 calls would advance to €20, which is a gain of 900 percent or €1,800! If the investor had bought the common stock for a capital outlay of €10,000 the gain would have been a handsome €2,000but the return on investment would have been just 20 percent. In this case buying an option was the correct course of action.
Limited Risk. One of the biggest advantages option trading has over outright stock trading is the ability to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his right and simply let the contract expire worthless.
Insurance. Another reason investors may use options is for portfolio insurance. Option contracts can give the risk-adverse investor a method to protect his downside risk in the event of a stock market crash.
Leverage. Of course leverage is a double-edged sword. If, in the above example, ABC common stock had remained at €100 through the life of the contract or worse, declined below the €100 strike level by the expiration date, the option would have declined to zero and the loss would have been 100 percent.
Cost. The cost of trading options includes commissions and the bid price is higher on a percentage basis than the underlying stock itself.
Complexity. In order to be a successful options trader, you must make an effort to educate yourself about how options work and different trading strategies. NYSE Euronext offers a wide range of classes suitable for both beginner and experienced options investors.
Time Decay. Options, by nature, are time sensitive. If you do not exercise a contract before its expiration date, the option will become worthless.