What are options

Options are a type of derivative financial instrument that is based on the value of an underlying asset, such as a stock. More specifically, an options contract offers the buyer to opportunity to either purchase or sell the underlying asset at a predetermined price and date. Unlike futures, however, options holders are not obligated to either buy or sell the asset if they decide against it.

Every contract will have an expiration date by which the holder must exercise the option. The stated price of an option is called the strike price. Options are mainly purchased and sold through retail or online brokerage firms.

Advantages of options

While they have been around for a while, options are currently becoming more and more popular. In the past, many investors and traders avoided options because they thought they were too complicated and sophisticated. However, this is changing. In fact, there are a few key advantages that options give to traders, which are discussed below.

Cost efficiency

Options have high leveraging power. As a result, a trader can obtain a large position, but with huge cost savings. This is because leverage allows traders to access a position despite only paying a fraction of what it is actually worth (the margin), with the rest being paid by the broker. This amplifies potential gains, making it attractive for traders who are looking to seek higher returns. That said, it is important that traders remain careful, as leverage can also magnify losses as well, as they are calculated by the position’s original value, not what the trader initially paid for.

Less risk

While there are situations where buying options can be riskier than owning other types of assets, such as stocks, there are also times when options can be used to hedge against risk. However, this depends on how the trader uses them. Options can be a less risky alternative for traders because they require less financial commitment. They also are relatively impervious to the effects of gap openings.

Options are also the most dependable form of hedge. This protects existing investments against potential losses. Traders can also use options to create strategies that offset the risks in their portfolio, thereby minimising downside risk.

More Strategic

Another major advantage of options is that they offer more investment alternatives to traders. Options are considered very flexible instruments. There are many ways to use them and recreate other positions. These positions are called synthetics.

Synthetic positions present people with multiple ways to gain the same investment goals. While they are considered an advanced option skill, there are other strategic advantages. For instance, a trader may want to short a stock. However, this action is very prohibitive, and many brokers do not allow the shortening of stocks. So, traders can purchase put options instead to get around this restriction.

Higher potential returns

Selling options, particularly covered calls, or cash-secured puts, can potentially generate some form of income for traders. Premiums received from selling options can potentially provide a consistent stream of income.

Diversification

Options add another layer of diversification to a trader’s financial portfolio. By incorporating options, traders can gain exposure to various asset classes and market conditions, spreading their risk across various positions. This means they are not putting all their eggs in one basket. So, if a few instruments are doing badly, traders still have enough instruments and assets to weather the storm and volatile market conditions.

Liquidity

Many options markets are considered highly liquid. This means that there is enough trading activity and volume to execute trades quickly and at favourable prices.

Low capital requirements

When it comes to trading options, they typically require less capital compared to directly purchasing stocks or other assets. As such, they offer an accessible entry point for traders who have limited funds.

Risk management

Options offer various risk management strategies. These include protective puts and collars, that help traders limit their potential losses and control risk effectively.

Flexibility

Options provide a wide range of trading strategies that can be tailored to different market conditions and risk profiles. Traders can use options as a way to speculate on market movements, hedge existing positions, or potentially generate some form of income.

Time decay

Options have a time value component to them. This means that when they approach their expiration date, their value may erode. Traders can therefore use this time decay to their advantage in certain strategies, such as credit spreads.

When are options better?

When you are looking to limit risk: Options can allow traders and investors to earn a stock-like return while still investing less funds. This way, traders can limit their risk within certain bounds.

When you are an advanced trader or investor: Seasoned and experienced traders and investors know how to limit their risk in the financial markets. They also understand the risks that arise when using a given options trading strategy.

Buy assets for better prices: For example, a strategy such as writing puts allows traders to potentially collect a premium for the potential to buy an individual asset at a lower price.

Allow traders to potentially generate income: Some brokers sell call options against their asset’s position or write put options as a way to potentially generate some form of income. Such strategies can potentially be attractive and relatively low-risk methods of using options.

Can multiply funds at a higher rate: Traders can potentially make a much higher return using options, but they also run the risk of a complete loss if they are not careful when using them.

Bottom line

On the whole, it is essential to remember that trading options typically involves some level of risk. The complexity of options trading means that traders require a thorough understanding of the strategies involved. Traders should thus carefully assess their risk tolerance, have a clear trading plan, and use risk management techniques to protect their capital if necessary. Seeking advice from other experienced options traders or financial advisors can also be beneficial, especially for those who are new to options trading.