Advantages of Trading Options

It's easy to understand why buying stocks or trading them is appealing to so many investors; it's relatively simple to do and there is definitely money to be made. Trading other financial instruments is often more complicated and this is probably why many investors and traders do stick to stocks. However, some of these other financial instruments can provide other benefits that stocks do not.

Options trading, in particular, has many advantages and there are plenty of reasons why this form of trading is worthy of consideration for anyone looking to invest. On this page we look at the main reasons for trading options and why it can be such a good idea, even if it is a more complex subject with so much to learn. The following topics are covered:

  • Capital Outlay & Cost Efficiency
  • Risk & Reward
  • Flexibility & Versatility
  • Disadvantages of Trading Options

Capital Outlay & Cost Efficiency

One of the best reasons for trading options is the fact that it's possible to make significant profits out of doing so without necessarily having to have large sums of money. Because of this, it's ideal for investors with little starting capital as well as those with larger budgets. The potential for big profits from small investments is largely down to the use of leverage. In very simple terms, you can use leverage to get more trading power from the capital you have.

For example, let’s say you had $1,000 to invest and you wished to invest it in Company X stock, currently trading at $20, which you expected to rise in value. If you chose to simply buy those stocks using your $1,000, then you could purchase 50 shares. If the stock did rise to, say, $25 then you would make a profit of $5 per share for a total of $250. This represents a 25% return on your original investment.

Alternatively, you could choose to buy call options on the same stock, giving you the right to purchase the stock. If call options with a strike price of $20 were trading at $2.00 each, you could buy 500 options which would enable you to buy 500 shares if the stock did go up. With the stock rising to $25, you could exercise your option to buy 500 shares, and then sell them immediately for a profit of $2,500.

After taking away your original investment of $1,000 to buy the options, you are still left with $1,500 profit and a return on your money of 150%.

This is a somewhat simplified example, but it does illustrate how you can generate sizable returns from whatever starting capital you have available. This is a clear advantage that trading options has over trading virtually any other kind of financial instrument. Quite simply, you can save money when taking a particular position on the relevant underlying security which enables you to make very cost efficient investments and trades. There are even a number of strategies that can be used specifically to reduce the cost of taking certain positions.

Risk & Reward

In some respects, the risk versus reward advantage offered by trading options is closely linked to the above point. As the given example showed, it's possible to make proportionately bigger returns from the same capital investment. We used this example to highlight that trading can be done with relatively small amounts of starting capital and it can be a very cost efficient way to invest. In addition, options trading can offer a much better risk versus reward ratio if the right trading strategies are employed.

It should be made clear that there are obviously risks involved, because there are with any type of investment. Some trading strategies can be very risky indeed, especially those that are very speculative in nature. The general rule is that the higher the potential return, the higher the level of risk involved. What is particularly great, though, is the fact that you can pretty much choose whatever level of risk you wish to take and trade accordingly.

The wide range of different options contracts that you can trade and the different orders you can place make it much easier to limit risk than it is when simply buying and selling stocks. As you learn more about options and the way they are traded, you will realize just how powerful a tool they can be when it comes to managing risk.

Flexibility & Versatility

One of the most appealing elements of options is the flexibility that they offer. This is in contract to most forms of passive investment, and even some more active forms, where there are limited strategies involved and limited ways to make money.

For example, if you are taking a buy and hold approach to investment and simply buying stocks to build a portfolio for the long term, there are essentially only two main strategies you can use. You can focus on long term growth and buy the stocks that should appreciate in value over time, or you can seek more regular returns and buy stocks that should offer regular dividend pay outs.

Of course, you can use a combination of the two and there are a few variations on the two main strategies, such as whether to make very safe investments that involve very little risk but a limited return or whether to take more risk for great potential profits. However, the fact is that there isn't really a huge amount of scope for using advanced strategies to increase your level of profits.

Even if you are actively trading stocks, there are certain limitations involved. In very basic terms, you can either buy stocks that you think will go up in value or short sell stocks that you think will go down in value. There's certainly a bigger range of strategies that can be used when taking the buy and hold approach, and a number of different methods that can be used to determine what trades to make and when. However, the flexibility and versatility in options trading means that you will find many, many more opportunities for making profits in any prevailing market condition.

For one thing, options can be bought and sold based on a wide variety of underlying assets. As well as speculating on the price movements of stocks, you can also speculate on price movements of indices, commodities, and foreign currencies. This fact alone means there are a huge number of identifiable opportunities for potentially profitable trades.

For example, you may have a particular skill for predicting changes in the forex (foreign exchange) market as well as a solid fundamental knowledge of a specific industry. You could use your skill in the forex market to trade options based on foreign currencies and also use your industry knowledge to trade options based on relevant stocks. The potential for finding suitable trades is almost limitless.

The range of actual trading strategies that can be used is also huge. In particular, spreads offer true flexibility in the way you trade. Whether you are looking to limit the risk of taking a position, reduce the upfront cost of taking that position, or attempt to profit from price movements in more than one direction, it's spreads that make for true versatility. They can also be used for hedging existing positions, which can be very useful in uncertain times. It's also possible to use options spreads to profit from a stagnant market, something that is very difficult when trading stocks.

Disadvantages of Trading Options

It's fairly easy to see why trading options is becoming increasingly popular among many investors. It's no longer just the professionals that are involved, because more and more casual investors and home traders are taking advantage of the benefits on offer. It isn't without its disadvantages though.

It's fair to say that mastering options trading is no simple task, and there is definitely a lot to learn. This is certainly the single biggest reason why it's still avoided by so many, as the complexities of the subject can seem overwhelming or even intimidating. It's certainly a major downside that it's just not as straightforward as many other forms of investment. The profits are there to be made. but it does take a lot of time and commitment to learn how.

Another disadvantage is the risks involved. While there are risks in any form of investment, trading options can be particularly risky, especially for relative beginners who don’t have a huge amount of experience. The very nature of options means that they can be used to limit risk, if you understand the strategies required, but this form of trading shouldn't be considered as risk free by any means.

If you are thinking about trading options, then you should certainly take the time to read the next page in this section: Risks Involved in Trading Options.