Pros and cons of options trading
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What is options trading?
Options trading was always popular among advanced traders, but as trading becomes more accessible, more and more retail clients learn how to use options to their advantage, regardless whether they’re longer-term investors or speculators looking for quick gains.
Keep on reading to get a better understanding of options and gain a deeper understanding of the most basic concepts of this product.
What is options trading?
Definition of options trading
Options is a collective term for financial contracts that give the right to buy or sell a certain product at a pre-agreed price. This opportunity is optional, you don’t have to use it, hence the name: option.
The pre-agreed price (or agreed-upon price) is commonly referred to as the strike price.
As this trade is based on a contract, it has some similarities with futures: it is a legal, standardized agreement between two parties over the underlying asset.
To trade options, you’ll need a broker that gives you access to the option markets. Usually, this is possible at most US and major international brokers.
An option is a contract that gives the buyer the right – or opportunity – to trade a stock (or any other underlying security) at a pre-negotiated price (strike price) by a certain date (the expiration of the option).
n exchange for this right, the contract buyer pays a premium to the seller of the contract.
Depending on whether the contract buyer would like a right to buy or sell the underlying asset, we distinguish two main categories:
Call options are options that provide the right – but not the obligation – to buy the underlying securities for a pre-agreed price before the expiry of the contract. In other words, a call options grants the buyer have the right to buy at the strike price, no matter what the actual market price of the underlying asset is.
Put options are options that provide the right – but not the obligation – to sell the underlying security for a pre-agreed price before the expiry fo the contract. In other words, it allows the buyer of the put option to sell a stock at the strike price, no matter what the actual market price of the underlying asset is.
Options Contract Timeframes Explained
Expiration Schedules
For equities, monthly options typically expire on each month’s third Friday. Heavily traded securities additionally offer weekly options, which expire on Fridays as well.
Practical Application
Suppose you wish to purchase a Tesla call option granting future stock acquisition rights. Your practical steps would involve:
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Selecting Tesla within your broker’s application
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Navigating to “Option chains”
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Choosing your preferred expiration date (Tesla offers both weekly and monthly varieties)
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Selecting an appropriate strike price
Following purchase, you may sell the option at any time without waiting for expiration. The contract value fluctuates according to underlying asset movement (Tesla shares in this instance), potentially generating substantial profits or losses even before expiration.
Expiration Mechanics
Within American markets, the Options Clearing Corporation automatically exercises any expiring equity or index option positioned $0.01 or more in-the-money at expiration.
For example, if your call resides in-the-money—possessing a $600 call while shares trade at $620—you will acquire shares at $600, with the stock appearing in your account by the following Monday.
Underlying Asset Variations
The underlying security encompasses numerous possibilities: ETFs, ETNs, futures, bonds, commodities, foreign exchange products, among others. Stocks remain the most prevalent underlying security. Each options contract typically represents 100 shares of the underlying stock.
American Versus European Options
The distinction between American and European options relates to exercise timing rather than geographical trading locations. American options permit exercise at any point before expiration, while European options allow exercise only at expiration.
- US options let you exercise your contract at any given time until the expiry
- European options can only be exercised upon the date of expiration
It is important to note that this distinction doesn’t refer to the underlying security being a US or European-based entity.
Individual stocks and ETFs (exchange-traded funds) have American-style options while equity indexes, including the S&P 500, have European-style options most of the time.
In practice, it rarely makes sense to exercise an option before expiry, because you lose some premium by giving up time value. It is more sensible to sell the option instead if you want to cash in your profits. This means that the difference between US and European-style options is not that significant.
What is options trading?
Pros and cons of options trading
Some pros/advantages include:
- Options can give leverage, while your possible losses can be kept in check. Traders can get a bigger exposure to the underlying stock or ETF than buying shares outright for the same amount of money, magnifying profits if the price moves up rapidly.
- Options can also reduce risk. For example, you can buy a put option for a stock you’re holding. As a protective put, this will let you have the upside if the stock price rises but protects you from a portion of the losses if the stock price falls.
- Options can be used to generate income. By selling options, you’re the one to receive the payment (the so-called premium) for the option. A low-risk example of this is when an investor sells covered call options on a stock he or she owns.
Some cons:
- Timing the markets is difficult, but when you buy options, market timing is even more important. If your thesis works out to be correct 2 days after your option expired, you’re not reaping any benefit, but you lose money.
- If you’re the one selling options, time decay works in your favor. However, be aware that selling options on instruments you don’t already own (called naked selling) can generate huge losses in a very short order if volatility picks up and prices go in the ‘wrong’ direction.
What is options trading?