by: Daniel Webb

This article looks at the potential advantages and disadvantages of using options. Understanding these are crucial for investors and present a factor to investors in formulating their option trading strategies.

What are the Advantages?

Options contracts present a lot of potential advantages to holders and writers:

Advantages for holders

o Protection

Call options give those investors wishing to protect their existing positions a way to ensure that their underlying assets (e.g. stock) can be put up for sale at a definite price within a specified time frame.

What’s more, put options potentially offer investors a way of considering at the same time as concurrently preventing their losses: in terms of say an option to purchase stock, the holder’s maximum potential loss would be the cost of the option (which would be realized in the case that he/she does not use the option); by contrast, were the investor to invest directly in the same stock, his/her probable loss would be the whole price of the stock (e.g. if the stock became worthless).

Additionally, as options entail a permanent responsibility on writers independent of market changes, it also form the probability for those properly positioned to produce earnings even when the market is declining.

o Leverage

Moreover, as put options holders, investors can most likely acquire “more bang for their money” (i.e. higher returns on their investments (ROI)) by controlling more equity with their money than would be the case if they were to purchase the relevant underlying assets outright.

Advantages for writers

Options also present a number of probable pros to writers. For example, in a “covered call” (i.e. where the option writer owns the property that is the subject of the option), the options premium in respect of that property can represent an additional source of income for the writer (without the writer having to dispose of that property) if the option expires before being exercised

General Pros

Also, the present market bid all investors, whether they hope to be holders or writers, with a broad collection of option contract models of varying complexity.

What are the Cons?

There are several potential disadvantages which investors should bear in mind while designing their option trading strategies.

For example, unused options are worthless once they have expired. Hence, if it has not been exercised prior to its expiration date, the holder will have effectively wasted the premium.

Also, as noted above, options can be very multifaceted and can entail a good deal of market observation in order to be used efficiently.

Tips for new investors

Novice investors thinking of becoming holders should first consider their own risk profiles: they should decide whether they wish to use options to leverage their existing capital, or to protect them against unwanted near-term market fluctuations (as above).

Investors should also factor in brokerage fees when considering the cost of options contracts. Undeniably, the cost may be higher on a percentage basis than the cost of trading in the essential stock.

Furthermore, there are a number of strategies available to investors, some more high risk than others. The neophyte investor would be best off staying away from the high risk end of the spectrum (e.g. becoming a writer on an uncovered call, i.e. where the writer grants an option over property that he or she does not possess – there is no hypothetical boundary on the losses that the writer may get under such an arrangement).

All investors must know the likelihood for options contracts to produce losses (e.g. where the size of the premium negates the profits made from the acquisition or disposal of the underlying asset).

Lastly, it may be more advisable for beginners seeking to make money trading stock options to initially only enter into options contracts as holders, rather than writers (owing to the greater potential risks facing writers).

The information presented in this article is by no means complete. Naturally, there are a lot more aspects one should think about in putting together effective option trading strategies prior to pitching into this potentially profitable venture and definitely, one would be sensible to completely comprehend the consequence beforehand.

Visit my blog on more information about how you can make money trading options and grab some free ebooks and e-courses along the way: http://www.savvyfinancialtraders.com