The Pros and Cons That Helps You Master Options Trading Strategies
Just like with any kind of investment you choose to work on, there are going to be some positives and some negatives that come with options trading. Exchange traded options started back in 1973, and now it is a common trading occurrence in the market. Although they sometimes gain the reputation of being a bit risky for investing, options can be useful and profitable for many types of investors. Let’s spend some time in this chapter looking at the benefits and the negatives that come with options trading.
The advantages of trading options
For this, we are going to take a look at the four main benefits that come with trading in options. These include:
- They can provide more cost efficiency than before.
- They are seen as a less risky investment choice compared to other investing choices.
- They can potentially provide you with a higher percentage of returns.
- They offer a few strategic alternatives if you choose to look through them.
Let’s dive a bit deeper into these options and take a look at how you are able to benefit from each part.
Cost efficiency
The first benefit that we are going to look at is that of cost efficiency. These options have a lot of leveraging power. Because of this, many investors are able to obtain a position in options that is similar to their stock position, but the options position is going to provide them with a big cost savings. For example, if you are trying to purchase 200 shares of the stock from a particular company, and they are market priced at $80 a stock, the investor is going to need to come up with $16,000.
But, if the investor were able to purchase two $20 calls, with each of these representing 100 shares, then the total would be $4000. We get this from the two contracts times the 100 shares a contract times the $20 market price. This means that you would have an additional $12000 to use at your own discretion with this method.
Of course, this is a rather simplified version of the events and often it is a bit more complex to work in options. As an investor in options you need to be able to pick the right call that you want to purchase and you must make sure that you are mimicking the position of the stocks in the proper manner. However, this strategy, which is known as stock replacement, is practical, viable, and cost efficient. Less risk involved
While there are some situations where purchasing the option is going to be riskier than owning the equities, there are also many times when owning these options can reduce the amount of risk that you take on. It often comes down to how you are using these. Options are going to be less risky for many investors because they won’t require as much of a financial commitment as equities do. They are also less of a risk to deal with because of their imperviousness to any effects that gap openings can bring out.
Options are also seen as a more dependable form of a hedge, and this can make them a bit safer to use compared to stocks. When an investor goes through the process of purchasing a stock, the stop loss order is what has to be in place to protect that position. The stop order is going to help prevent the investor from losing more money beyond a specific point. The problem with these is in the nature of the order. A stop order is going to be executed once the stock trades at or below the limit that you indicated in the order.
This can help to safeguard your investment, but there are times when it doesn’t work. If something happens overnight to your stock, for example, it is possible that you would have to trade below that stop loss point, even if it were in place. But if you had purchased a put option to keep yourself protected, the loss wouldn’t have been so big. Unlike the stop loss orders, these options aren’t going to be able to shut down when the market closes, and they will provide you with a form of insurance 24/7, something that stop orders just aren’t able to do. This is one of the main reasons why options are seen as a dependable form of hedging with many investments.
Higher potential returns
When you enter into the market, your goal is to earn as much profits as possible. You don’t want to waste your time and your hard earned money on trades that only bring in a small percentage. And the more that you can make on a trade, with the least amount of risk possible, the more enticing that particular trade is going to look. And you don’t need to use a calculator to figure out that if you are able to spend less money on options, and still make the same profit as actually purchasing the stocks, you are going to end up with a higher return potential than before.
Many people like to work with options because it can provide them with a huge amount of return on investment. They like that they don’t have to spend as much money on the options, and they can still earn a good return on that investment. And because these options can work no matter what kind of market you are in, it is an attractive method to use to see some great results.
More strategic alternatives
The final bit advantage that comes with trading in options is that they provide you with more alternatives to investing than others. Options can be a tool that are very flexible. And there are many ways to use these options in order to recreate the positions that you want. We know these positions as synthetics.
These synthetic positions will present investors with many different ways to reach their goals with investing, and this can make them very useful. While these positions are going to be seen as a more advanced topic with options, these options are still going to offer many other strategic alternatives that you can work with.
For example, many investors will choose to work with a broker who will charge them a margin when they are looking to short sell a stock. The cost of this can sometimes prohibit many traders from entering into that kind of trade unless they really know that it is going to work in their favor, and in a very profitable manner. This means that many investors who want to short sell, but who use a broker, just won’t be able to short the stocks at all. The inability to play the downside when it is needed can really limit the kind of investment that you are able to do.
But what is unique is while there are a lot of rules about margins and selling stocks on the downtrend, brokers don’t have any rules about purchasing puts and then using those to play the downside that happens in the market. This can make options trading a very big benefit for some investors who don’t want to be stuck with just trading one side of the market all the time.
The use of options can help the trader to work with all the different situations that occur in the market. Options make it easier to trade with stock movements, the movements in volatility, and even those that deal with the passage of time. most stocks don’t have big moves for the majority of the time. And it is actually just a few stocks that move in a significant manner. And even when this happens, it is pretty rare.
Your ability to work with options and even take advantage of stagnation could be one of the best factors in deciding whether the financial goals you have are actually reached. But you are only able to do this and profit from all types of markets with options.
The negatives of trading options
Now that we have spent some time looking at trading options and all of the benefits that come with it, it is time to take a look at some of the negatives that can also occur. The options market can provide a lot of benefits, but it doesn’t work as the best investment strategy for everyone. There are a number of reasons why someone may choose to not trade options at all and will choose to go with another type of strategy or investment instead. Some of the negatives that come with trading options includes:
Taxes
When you are working with options, you need to be aware of the taxes that you are going to owe if you earn any profits on your trades. Except in some rare circumstances, all of the gains or profits that you make on your options trading are going to be taxed as short term capital gains. This essentially means that they are going to be taxed similar to your regular income. And the rates of the gains that you earn are going to be as high as what you pay for your individual personal income rates.
Because of this situation with your taxes, you may have to make some changes in the way that you accept these gains. Since you aren’t going to be able to have your employer or someone else take some money out for taxes each month, you don’t want to ignore the taxes until the end of the year and then be surprised at your tax bill when you file.
One option is to work with is to carry out your option strategies with the help of a tax deferred account like an IRA. This allows you to reduce your tax bill at the end of the year and ensures that you start saving up for your retirement for later in life. This may not be possible for everyone though. If this method isn’t one that works for your needs, you may need to talk to your tax professional to help you prepare in the proper way for these taxes.
Commissions
Another thing to consider when it comes to working with options trading is the commissions that individual traders are going to need to pay. Compared to investing in stocks, commission rates for options can be really high. Most brokers are going to charge a very high rate when it comes to these commissions, and if you are not careful, this can end up eating up all of the profits that you tried to earn.
It is not uncommon for some brokers to charge more than 30 percent of the amount that you invest into the trades as their commission. This can quickly eat away at any profits that you make, unless you really make some big profits on each trade. This can turn away a lot of the investors who are looking to save money and save money.
Before you decide to get into options trading, you should talk about commissions with your broker ahead of time. You should have a full understanding what they are going to charge you for each of the trades that you end up doing. And you should always be wary if there is a newsletter that doesn’t include commissions in the results that they post. This is a sign that they are trying to mislead you and at the very least, they aren’t willing to provide you with all of the information that is needed.
Big fluctuations in the value of different portfolios
Options can be a leveraged instruments. The portfolio values are going to experience a lot of beg swings in value in both direction. While your portfolio could include a good return on investment overall, there can always be a lot of volatility that comes in with these portfolio. Your results can be at losses of 31 percent or more, and then they could have gains of 20 percent the next week. This is just a normal part of the process.
But for some people, it is hard to stomach all of this volatility. Some people don’t mind if there is a lot of volatility that occurs in the market. but then there are those who get really worried about some of this volatility and they don’t want to put as much risk with their trades as what can happen with it. Just like some people are worried about how much they are paying in commissions, others will be worried about how much volatility can happen in their portfolio.
The uncertainty of gains
When you are carrying out some of your strategies with options, most prudent investors will decide to depend on a risk profile graph to show them the expected gains or losses at the next options expiration at the various possible prices for whichever underlying asset you want to use. These graphs can be really important when you want to figure out where you place those initial positions. And as long as you are in the trading position, you will want to consult these each day during the week as well.
In many cases, when it is time for a particular option to expire, the gains that you expected are not going to materialize like you had hoped. The reason for this is because the option prices, ended up falling. The risk profile graph software is going to assume that the implied volatilities that you started with are going to keep constant the whole time, but this not realistic. There are many times when the volatility is going to rise and sometimes when it goes down. There are some weeks when you are going to do better than what the risk graph projected for you, and then there are times when your trades are going to be lower than projected. And in the process, you may not make the gains that you had hoped to in the first place.
It can be hard to get into a market when you are uncertain about the gains that you are going to receive. Even those who spend their time looking through charts and paying attention to the risk profile and more will find that they are still going to be uncertain about the kinds of gains they can get from some of their own options trades.
With all of the negatives that come with options trading,
you may start to wonder if trading in options is actually worth your time. You
have to take the time to weigh the positives that we talked about against some
of these negatives, and then determine if it is the right investment
opportunity for you to use.
