An option is a trading instrument that allows an investor to buy or sell an underlying asset or security. Unlike stocks, they do not represent ownership of the particular security. Futures use contracts just like options, but the latter is low risk because the investor can withdraw from options trading at any point.
The price of options contracts is, therefore, a percentage of the underlying security. So why would an investor consider options trading? It is because they allow them to bet on stocks going up or down or hedge a trading position in the financial markets.
There are two types of options in the derivatives market: Call and put options. The call option is one that gives a trader the right but not obligation to buy the underlying asset at a specific price.
A put option provides a trader with the right but not obligation to sell the underlying asset at a particular price. The rate at which you agree to buy the contract as you exercise the option is the “strike” price while the fee you pay for the contract is the “premium.”
Pros of Option Trading
Options trading is quite pocket-friendly for small traders. By trading in these contracts, they significantly reduce the cost.
Take, for example, an individual who wants to buy 50,000 shares of a top league company such as Apple Inc. The call option of those shares will cost way lower than the cost of an actual stock of the same company.
It, therefore, allows players from all classes to join in the trade.
With options, they limit the risk to the investment you engage in. Imagine in the same scenario where you buy options of 50,000 shares of Apple Inc. and for some reason, the prices in the shares tank. The losses you would incur in having options are lower than those you would incur in having actual equity in the company.
Higher potential returns
You spend a minimal amount of money investing in option contracts and make huge profits in return. It allows you to invest in small amounts and almost make the same profit as the person who has actual equity in our example of Apple Inc. Of course, it is a two-sided coin where if the trade goes the other way, you incur heavy losses as well.
Options trading is quite flexible in that you can alter your strategies as per the market conditions. There are several strategies available to investors for different kinds of markets. They include long call, long put, bull call spread, bear put spread, long straddle, short straddle, and so on. You can switch up the strategies as you see fit.
Financial markets expose every trader to some level of risk. Hedging is a strategy of protecting your trades from incurring losses. Unlike stop-loss orders in the case of stock and forex trading, options remain open when the market closes.
You have insurance on your investments 24/7, and that is why investors prefer option contracts for hedging against risk.
Cons of Option Trading
Options trading is quite complicated. To obtain substantial profits, an investor must observe the trades consistently going through the ups and downs.
It is especially challenging for beginner investors who do not have the skills to analyze the trading options critically. Numerous strategies require one to understand well to know which ones to execute at what point. It takes time to master them.
When there is a lack of liquidity in the financial markets, there is a higher spread. It troubles a lot of investors who trade-in options. Furthermore, there are a lot of indirect costs in trading options as compare to stock trading. When there are high spreads, the investor pays more commissions for both sides.
Availability of information
Another challenge with options trading is the difficulty that comes in when trying to get information on quotes and analytics. Moreover, unlike stock trading, options impose a limit since they are not available for all securities listed on BSE and NSE.
The term refers to losing value over time. Traders who buy options lose value on their contracts as time closes in on the expiry date. Therefore, that is something that traders should watch out for, especially beginners. The value of options is always falling.
In conclusion, options trading is a very speculative investment opportunity with substantial risk and reward as with any lucrative venture. Before you go all in, ensure you have thorough knowledge on how to go about options trading.
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