Options are derivative instruments which are used by the traders and investors to hedge the risk against the market movement by paying premium. In order to understand it better let’s look at some of the advantages and disadvantages of options
Advantages of Options
- The first and foremost advantage of options is that they allow investor or trader to take position with small amount, so for example if an individual has $2000 and price of Google stock is $100 then if he or she is of the view that Google share price will rise in near future then in cash market he or she can buy only 20 shares of Google whereas in case of options if the call price of $100 call of Google is $5 then an individual can buy 400 options with $2000. So if the price of Google rises to $110 then by buying stock the investor would gain only $200 whereas call option buyer would be making $2000($110 – $5 of premium). Hence an individual is making 10 times more money in case of options as compared to buying stock.
- Another advantage of options is that they provide investors with ample strategies so as to profit from volatility in stocks, so for example if an individual feels that during a particular month price of Google will fluctuate but does not know the direction then he or she can use options to profit from such situation. Hence if the price of Google is $100 and investor expects a volatility of 20 percent then he or she can buy $105 call and $95 put and the total premium cost of both the options is $10 then in the event of price going either above $110 or below $90 investor will benefit from options.
- An individual can also use options for hedging purpose so suppose an investor has total portfolio of $50000 stocks and he or she wants to reduce risk due to volatility in market then an investor can buy index put options so in the event of market going down the loss due to fall in stock price will be set off by gains in index put options.
Disadvantages of Options
- The biggest disadvantage of options is that they are very risky and the value of option can be zero on the expiry so in the above example of Google if the price does not rise and individual has bought 400 options then investor entire sum of $2000 would be of no value as option will expire worthless and if the investor has bought 20 shares then his or her capital would have been safe. Hence options are like critical medical operation if operation is successful then an individual will survive and if fails then it will lead to death of an individual.
- Another disadvantage of options is that they are less liquid as not many people trade in options market and therefore in case of options liquidity is very less as compared to equity market. Due to low liquidity it is not easy to buy and sell which in turn leads to one selling at lower rate and buying at higher rate as compared to those markets which are very liquid.
- Complexity is another issue with options because most of options strategies are complex and it requires proper understanding of finance before executing such options strategies resulting in it being out of reach for common man as not everybody has financial expertise to carry out complex options trade.
As one can see from the above that option has benefits as well as limitations and any person thinking of doing option trading should carefully examine the pros and cons and then decide whether to do option trading or not as any mistake in option trading can result in huge losses for the person doing option trading.