Advantages and Disadvantages
Please note - Trading or investing in options, future derivative and in stocks are individual preferences so we advice to everyone to go through all advantages and disadvantages and then take the decisions.
The Advantages of Options
Many investors and traders have avoided options, believing them to be sophisticated and, difficult to understand. Many more have had bad initial experiences with options because they have not taken proper training in how to use them. The improper use of options can lead to major problems.
Finally, words like "risky" or "dangerous" have been incorrectly attached to options by the financial media in the market. However, it is important for the individual investor to get both sides of the story before making a decision about the value of options.
In following section both advantages and disadvantages are explained.
There are four major advantages that options may give an investor/trader.
1. Big Leverage
Options provide big leverage power.
The following example will show how option provides benefit and leverage.
Suppose if you are expecting the HDFC stock which is currently trading at Rs 1700 (the current price while writing this note) will go to 1800 or above in next week or in next 15 days and decided to buy 50 shares which will cost you Rs 85,000.
On other note if you feel that investing so much of money is not possible at this time then you can plan to buy one lot of HDFC Call option (options are bought in lot and one HDFC lot consist of 150 shares) of strike price 1800 would cost of around Rs 10,5 00 (approximately).
So this is how the options provide leverage.
So going forward if the HDFC stock price rises even to Rs 1750 you are making Rs 50 per stock and you have 150 shares (one lot of call option) so you are making profit of Rs 7500 by investing Rs 10,500.
2. Limited Losses
There are situations in which buying options is riskier than owning equities, but there are also times when options can be used to reduce risk. It really depends on how you use them.
Options can be less risky for investors because they require less financial commitment than stocks.
Now let's see how options provide limited losses as compared to unlimited losses in stocks.
In case of stocks
For example, let's take above HDFC stock, say you bought it at Rs 1700.
Now say you go to bed with the stock having closed at Rs 1750 and the next morning, when you wake up and hear that there is breaking bad news on your stock and the stock opens down around Rs 300 or even down which will considerable loss to you.
In case of Future derivative
Suppose if you bought one lot of future derivative at certain price and if the price starts falling then the losses are unlimited.
In case of options
Whether you buy call option or put option the losses are limited. In case of options the maximum loss is the price you paid to buy it (it is called as premium).
It doesn’t matter how much the stock price falls, your loss is the amount you paid to buy the options.
You can even minimize these losses in options by hedging. Hegding means buy put, if you would have already bought call and vice versa. (How to do hedging is explained in our next sections)
3. Higher Potential Returns
The returns in options is higher as compared to investment done in either in stock or in future derivative.
As you can easily come to know in above example of HDFC mentioned under heading “Big leverage”.
The second way for higher returns in option is the term called Delta.
Delta is the figure in percentage which is higher for “in the money call options” and lower for “out of money options”.
Delta indicates the percentage change with respect to change in the underlying.
This will be explained in our next sections.
4. Lots of ways to trade in options
The final major advantage of options is that they offer more investment alternatives to make money as well as to reduce risk.
Options are very flexible tool. There are many ways to use options to recreate other positions.
You can buy options to make profit from either stock movement or from Nifty movement.
You can trade on options when you know the direction and even when you are not aware of the specific direction.
You can buy options to make profits from your stocks you already have in your portfolio.
You can buy stocks to minimize the losses in your future derivative position.
And many more which are explained in other sections.
The Disadvantages of Options
As options are having great advantages and provides various ways to make money and minimize losses there are also few disavantages which are mentioned below,
The costs of trading options taking into consideration the brokerges rates are significantly higher on a percentage basis than trading the underlying stock or future derivative, and these costs can drastically eat into profits.
So choosing low brokerage rates is very imporant.
With the vast array of different strike prices available, some will suffer from very low liquidity making trading difficult.
So choosing right options strike price is very imporant.
Options are very complex to understand and require a great deal of observation and understanding to make profits. Trading or investing in options is not as easy as we do in stocks or in future derivative.
So study the basics and all teminoology, stratetgies and techniques about options.
4. Time factor
The time-sensitive nature of options leads to the result that most options expire worthless. This only applies to those traders who buying options while on the other side short sellers of options collect the premium (make profit) so due to time factor in options, most of the time, short sellers make prodit in options.
5. Unlimited Risk
The short selling of options contains unlimited risk. (which you will come to know as you proceed reading our other option articles).
On the other hand buying options contains limited risk as you tend to loose only the amount you paid in buying the option irrespective of how much the stock price falls.
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