Exchange-traded options have been around since 1973 and offer a range of advantages for the individual investor. Despite the reputation for being a complex and risky investment, options can be a valuable tool for managing risk, generating income and increasing returns. In this article, we will explore the benefits of options and how they can be incorporated into an investment portfolio.
Key Takeaways:
Options are contracts that grant the buyer the right, but not the obligation, to buy or sell a set amount of an underlying asset at a predetermined price before the contract’s expiration date.
When used as a hedging tool, options can help reduce risk in an investment portfolio.
For speculators, options offer a lower-cost way to bet on market movement with limited downside risk.
Options also provide traders and investors with more flexible and advanced strategies such as spreads and combinations that have the potential to be profitable in any market conditions.
Benefits of Trading Options:
- Increased cost-efficiency: Options can provide increased cost-efficiency compared to traditional forms of investment. By using options, investors can gain exposure to a particular asset at a fraction of the cost of buying the asset outright. This allows investors to put their capital to work more effectively and maximize their returns.
- Less risky than equities: Many investors view options as being riskier than equities. However, this is not always the case. Options can be used to hedge against potential losses in other positions, which can help to reduce overall portfolio risk. Additionally, options trading allows investors to limit their potential losses by setting stop-loss orders, which can be helpful for risk management.
- Potential for higher percentage returns: Options trading has the potential to deliver higher percentage returns than traditional forms of investment. This is due to the leverage options provide, which allows investors to control a large amount of an underlying asset with a relatively small investment. This can increase the potential for gains, but it also increases the potential for losses.
- Strategic alternatives: Options provide a wide range of strategic alternatives for investors. They can be used for speculation, hedging, income generation, and risk management. This flexibility allows investors to tailor their options trading strategies to suit their individual investment goals and risk tolerance.
Cost Savings
Options trading can provide investors with significant cost savings compared to traditional stock purchases. Through the use of options, investors can gain exposure to an underlying asset at a fraction of the cost of buying the asset outright. This is known as stock replacement strategy.
For example, an investor who wants to purchase 200 shares of a $80 stock will have to pay $16,000. However, the same investor can purchase two $20 call options, each representing 100 shares, for a total cost of $4,000. This allows the investor to have an additional $12,000 to use at their discretion. While this strategy is not as simple as it may seem, it is practical and cost-efficient.
The key is to choose the right call option that closely mimics the stock position. By using options in this manner, investors can save money and have more flexibility in their investment decisions. In the given example, an investor who wishes to purchase the stock of ABC Corp. at $131 per share for 200 shares, will have to pay $26,200. Instead, the same investor can go into the options market, pick an option that mimics the stock closely, and buy the August call option with a strike price of $100 for $34. Buying two contracts of this option will bring the total investment to $6,800 instead of $26,200. The difference can be used for other investment opportunities or to gain interest.
Risk Mitigation When Used Correctly
Options trading can be a less risky way to invest, when used properly. Unlike equities, options require less financial commitment and can be used as a form of hedging to reduce risk. This is because options are relatively impervious to the potentially catastrophic effects of gap openings. Options are often used as a dependable form of hedge and can be safer than stocks.
When an investor purchases stocks, a stop-loss order is frequently placed to protect the position. However, the problem with stop-loss orders is that they may not be effective in certain situations, such as gap openings. For example, let’s say you buy ABC, Inc. stock at $50 and place a $45 stop-loss order to protect your investment. However, if there is negative news about the company, the stock may open significantly lower, causing you to lose more than you had anticipated.
In contrast, purchasing put options for protection would not have resulted in such a catastrophic loss. Options are active 24/7 and do not shut down when the market closes, unlike stop-loss orders. Additionally, the strategy of stock replacement, where an investor purchases an in-the-money call option instead of purchasing the stock, can also limit the potential loss. Options trading can be less risky than equities when used properly, as they provide a dependable form of hedging and can limit the potential loss
Higher Potential Returns
Options trading can offer higher potential returns for investors. Due to their lower financial commitment and leveraging power, options can provide a higher percentage return when they pay off. For example, if you purchase a stock at $50 and an option at $6, the option has a delta of 80, which means the option’s price will change 80% of the stock’s price change. If the stock were to go up to $55, your stock position would provide a 10% return. However, your option position would gain 80% of the stock movement (due to its 80 delta), or $4. A $4 gain on a $6 investment amounts to a 67% return— much higher than the 10% return on the stock. Though it’s important to keep in mind that options trading also carries the risk of losing the entire invested amount.
A Wide Range of Strategies
The final advantage of options trading is the wide range of investment options it provides. Options are a versatile tool that can be used in many different ways to achieve the same investment goals. Synthetic positions, which are considered advanced options topics, offer investors multiple ways to achieve their objectives. Additionally, options trading offers alternative strategies for investors who are looking for more flexibility. For example, many investors use brokers who charge a margin when shorting stocks, which can be expensive. However, options trading allows investors to purchase puts to play the downside, which is a cost-effective alternative. Options trading also allows investors to take advantage of the market’s “third dimension” which is non-directional trades. Options allow investors to trade not only stock movements but also the passage of time and movements in volatility. This can be a valuable strategy for investors looking to profit in every type of market.
In conclusion, options trading is gaining popularity among individual investors for good reason. The advantages of cost-efficiency, reduced risk, higher potential returns, and a wide range of investment options make options a valuable tool for any investor looking to diversify their portfolio. With the advent of online brokerages, retail investors now have easy access to the options markets and can trade options at low commission costs, giving them the same level of power and flexibility as professional traders. It is important for individual investors to take the time to learn how to use options correctly and make the most of this powerful tool. The opportunities provided by options trading are vast, and investors should not miss out on this chance to expand their investment strategies.
