08:02 AM, 02 Mar 2024 (AUS EST)   The market is currently closed       

Why Trade Options?

Before we part with a single hard earned dollar we should ask ourselves, "Why should I invest with this?" If you asked yourself why you should put money into options instead of the bank, stocks, or any other investment, you are already on your profitable path to success with critical thinking.

With so many different products on the market, why choose options? Here are a few compelling reasons:

Options Provide Massive Leverage

Both options and CFD’s give the investor a large degree of leverage over the outright purchase of the underlying asset. Options purchased ‘at the money’ with a few months of time value will usually give leverage 5 to 20 times that of purchasing the underlying stock. As well, you cannot lose more than the purchase price of the options contract.

The example below will highlight the difference in cost and return between options and stocks. The chart will depict the buying of 1,000 shares of a stock that went from $10 to $12 per share. One options contract represents 1,000 potential shares.

  Option Stock
Bought Aug.15th $1,000 $10,000
Sold Oct.15th $2,475 $12,000
Profit $1,475 $2,000
Return on Investment 147.50% 20%

Passive Income Generation

Writing options on stock you already own allows one to generate extra income for doing little more than owning shares. If you own the shares when writing options, you may also benefit from any dividends paid out. This type of income generation is called covered call options writing. Be aware that you may need to hand your shares over if certain criteria are met. This income strategy is unique to options, and cannot be performed with CFD’s.

Writing options without owning the underlying asset is called naked options writing and is much more hazardous with potentially unlimited risk. This should not be performed by new options traders.

Effective Risk Management

Wouldn’t it be great if we could buy shares in a company with high profit potential, and then buy insurance against falling prices? You can do this very thing with options. Many traders who take up positions in volatile stocks, or trade during rocky economic conditions, will hedge themselves with options contracts. While CFD’s provide massive leverage, they do not have the ability to limit risk in the same way options do.

Should the stock or market tank, the option value will offset much of the losses sustained by the underlying asset.

Small Capital Outlay

Speculation on the market can be risky. Therefore, the best speculation provides large upside gains (as discussed in the leverage heading) with small capital outlay. Compared to the outright purchase of stock, options can be done with far less capital. While CFD’s also require a small capital outlay since it is heavily margined, they may require additional funding if the market turns against you.

If the trader anticipates an upward move, a relatively cheap call option can be purchased. If the investor feels the market will correct, put options can be acquired that will rise in value as the market drops. As long as you sell your contract and do not exercise it, you do not need to come up with more capital to convert the contract into shares. In fact, you will gain extra extrinsic value from the value of the contract itself.

Options for the Unsure Trader

Imagine you get a hot tip from a friend and you want to act on it, but you also have some reservations. Or you might feel that the current price of a certain stock is undervalued, but the market conditions make you hesitant to buy a large position. These issues are easily resolved with the purchase of a call options contract. CFD’s cannot give you the same type of agreement that allows you to purchase shares if you want, but without any obligation.

The amount of time remaining in the call option contract provides you a window of opportunity to lock in at an agreed upon price. You can buy an options contract and wait a few months (or however long before the expiration date) to finally decide to exercise it and take possession of stock.

A Diversified Portfolio

Having many different investments can require a large amount of capital. Traditionally, those investors with smaller amounts of capital had to choose one or two investment types only. With the low cost of options, investors with smaller nest eggs can still have a diverse portfolio that will protect them when one part of the economy falters while another rises.

Balancing the Advantages of Options

Just because we listed quite a few advantages to options, this does not mean that there are not risks or downsides associated with them. Before you pull your retirement fund to invest with options, you should read through the risks to see if they are right for you. If options still seems good after reading further, then by all means you should use this highly leveraged investment vehicle.