Pros and Cons of Option Trading

Although options trading offers more strategic freedom to the investors than they obtain by merely buying and selling stocks in the stock market, however, there are specific pros and cons of options trading that an investor must be aware of before choosing this complex segment. 

But, before moving ahead with these pros and cons, let us quickly understand what options are?

As you might be aware, there are a plethora of trading and investment segments in the investment world, such as equity, mutual funds, currency, commodity, derivatives, IPO (Initial Public Offerings), and a lot more! 

The segment Derivatives is further classified into two different parts, namely Future and Options. 

Also Read: Difference between futures and options

An option is a type of contract that gives buyer and seller the right but not obligation to buy or sell the stock, shares, or other securities respectively before the expiration of options contract and at a fixed price. 

This fixed price is also referred to as Strike Price, and this price, once fixed, never changes even if one suffers a loss. 

Options are further classified into two different categories, namely, Call Options and Put Options.

Now, let us quickly have a glimpse at the pros and cons of options trading and know whether we should opt for them or not. 

We will begin with the pros of options trading. 

Advantages of Option Trading

No doubt that investors can use options to protect themselves from sudden losses. 

Also, options are a great way to increase return on an existing or on a new position and certainly is a risk-management technique used in snagging a loss prevailing in all sorts of market conditions. While making sure that you understand the differences between Option Trading Vs Stock Trading, let’s take a quick look at the benefits of the former in this section.

Here are some of the advantages of options trading that an investor avails while using them-

1. Lower Upfront Financial Commitment

Options are a great way to lower your upfront financial commitment. For a regular trader or an investor, the upfront trading amount to purchase a stock, shares, or any other security outrightly is quite a bit. 

However, if you opt for options, you will be required to make a few upfront trading commitments that include premiums and trading commission. 

So, definitely, buying an option is a lot less costly than an investor has to pay for other stocks prevailing in the stock market.

2. Limit your potential losses

When an investor buys a Call or Put option during his trading deal, he is not obliged to follow the prices during the entire contract.

Rather, if you feel that the trading deal can result in potential loss, then you can limit it by using options.

So, during the validity of the option contract if the prices of the stock go reverse to your assumptions then you can quickly trigger the option contract. 

---

Let’s understand this with the help of an example-

In this Options trading example, let’s talk about Rakesh.

Rakesh has 1000 shares of Reliance Industries Pvt. Ltd. whose current price is ₹500 per share. He is bullish on the share price but at the same time does not want to suffer a loss in a long run.

He then decided to get into the options trade and paid a premium of ₹5000 to Suresh at a strike price of ₹490 option contract expiring after 3 months.

Now on the expiry date, the price of share drop by ₹50 per share and reaches ₹450, here is the time when Rakesh can protect himself from loss and push Suresh to buy the shares at the strike price of ₹490 thus minimizing his loss even in the bearish trend. 

Calculating the loss with or without option contract. 

Without options contract:

Loss per share= ₹50

Total loss = 1000*50

    = ₹50,000

On the other hand, 

Loss per share= ₹10

Total loss = ₹1000*10

  = 10,000

But in the option contract, Rakesh also paid a premium of ₹5000, thus facing a loss of ₹15,000 which is still less than the major loss of ₹50,000.

---

3. Offers Built-in Flexibility for Investors

Without a doubt, options provide complete flexibility to investors by allowing them to deploy multiple strategic moves before an option contract expires. 

The investor is free and independent to proceed with the below strategies anytime during the trading deal-

• Exercise the options trading to buy a company shares, and then sell a few or sell the entire volume
• Exercise the options to buy the shares and add them to your investment portfolio.
• Sell the “in the money” option contracts  to another stock market investor or trader 
• Finally, you can make back some of the amounts spent for this  “out of the money” option by selling your contract to another trader or investor while the contract is still valid or has not expired.

Hence, through options trading, you get a plethora of flexibility to handle your profits and to lower the losses that might affect your trading deal. 

Now, it’s time to understand the next point! 

4. Conveniently Fix a Stock Price

Contrary to regular stock market trading, options trading allows an investor to freeze the amount to sell or buy his stock, shares, or other securities. 

So, you can quickly fix the price for a particular duration that perfectly suits your trading requirements.

Depending on the type of option an investor uses, it assures that they have the right to buy or sell the stock or share before the expiry of the date, which no other trading offers! 

5. Higher Possible Return

Definitely, with options, you can avail higher potential returns as the amount will be chosen by you and also, in case you feel that the market will fluctuate with time and price will go higher, then as a seller, you can earn maximum returns in the coming future. 

In case you are a current option seller, then there are two distinctive ways of receiving returns: premiums and the entire trading deal price. 

Thus, options offer maximum profits or returns as, firstly, you choose or fix the stock amount. Secondly, you can execute the trading deal within the validity of the contract to make attractive profits.

Finally, coming to the last advantage of option trading! 

6. Avail of Multiple Option Strategies 

Through options, you can create diversified option strategies with the help of call and put options.

If you are a buyer, you can opt for the call option that gives you the right to buy a stock, share, or any other securities at a given amount(which is also known as Strike Price). 

On the contrary, if you are a seller, then by using the put option, you get the right to sell the stock or any other stock market asset in the predetermined amount within the validity period of the option contract if the stock price falls drastically.  

You can pick the right kind of option and strategy by using the best indicator for option trading.

You must also know that unlike futures contracts, they don’t provide you the obligation, instead give you the right on the trading deal.

Apart from this, there are several other advantages of option trading such as attractive leverage, a tool of greater flexibility, protection against market fluctuations, and many more! 

To reap these advantages one must first understand the option trading basics. This helps them to know what is option trade, and how to execute the right trade in the ongoing market trend in order to maximize profit.

---

Disadvantages of Option Trading

It is clear that every aspect has a few pros and cons too. Then how can option trading be neglected? 

Although each trading and investment segment has its benefits as well as risks, however, it’s necessary that the risks must be genuine and solvable. So, let’s look at some of the disadvantages of option trading.

Below are some of the disadvantages related to option trading and if you are also doing such trading or thinking to do, then you must miss these points! 

So, here they are-

1. A Higher Loss to Sellers

In contrast to an option purchaser (or holder), the option seller, which is also known as a  writer, can bring about a higher volume of misfortunes, much more than the cost of the entire cost of the agreement. 

Keep in mind, when an investor opts for a put or call option, the person is committed to purchase or sell shares at a fixed value (Strike Price) during the agreement’s time span, regardless of whether the cost is favorable or not (and there’s no cap on how high a stock cost can rise). 

---

To give you an idea, let’s understand the same with the help of an example-

A seller named Sanjay Dutta has purchased 1000 shares of a company at Rs. 7,98,000. Later, he wishes to sell all of them at Rs. 9,98,600 so came in option contract with Vikas Gupta. 

Vikas Gupta, as a buyer, holds call option, and pay the premium to get the right to buy the shares at the fixed price at Rs. 8,08,000, irrespective of the situation that the price goes above or falls down. 

When Vikas Gupta observes that the market is doing up, he suddenly buys those shares with the aim to sell them later when the cost is relatively higher. 

Now, Sanjay was left with no other way. He had gone through a considerable loss as the prices had risen steadily higher than his value. 

---

Now, we believe that you have understood the concept and also the Option trading risk factor related to the higher loss to the seller Thus a proper strategy can help you to gain a stress free trading system and can lead you to profits as well.

Also Read: 7 Common Options Trading Mistakes

2. Limited Time

The very nature of options is the short term. Options investors are always hoping to benefit from a short term price fluctuation, which should take place within a few days, weeks, or months for the trading exchange or agreement to pay off. 

To achieve the same one requires making two different assumptions: picking the ideal time to purchase the option agreement and choosing precisely when to exercise, sell, or leave before the option terminates. 

So, in this shorter period, making the right choice is very difficult as well as risky.

On the contrary, the long term stock investors aren’t on a cutoff time. They have a huge time — a long time, even many years — to let their investment strategies to stock market to play out.

3. Big Hit of High Leverage 

The third major disadvantage of option trading is the biggest hit when it comes to leverage.

Many times due to unfavorable stock market, most of the investors face losses, and major issues come when they have to pay back the leverage amount back to their stockbrokers.

Although the option contract requires less upfront payment as compared to the stock trading. However, sometimes paying this amount is a bit difficult which is why many investors take a loan or leverage from their registered brokers.

They are charged with a certain interest in getting leverage, and they are expected to pay all the amount once the contract expires or terminates. 

So, in case if the seller suffers loss then it will be a major issue for him as the leverage will be difficult to pay, especially when the interest rates are much higher. 

4. Lower Liquidity

Many investors believe that the major drawback of options trading is the lower liquidity. Since options are held for certain days or weeks, a stock may rarely experience any higher fluctuations. 

Therefore, due to fewer fluctuations and low sales and purchases, the profit is relatively lower, and also, in such a short duration, it is difficult to analyze the movement of stock. 

On the other hand, if you are a delivery trader who has opted for futures trading then you will get much more time to make huge profits as the contract is valid for several months and years too. 

Sounds profitable! Right?

5. Higher Brokerage Charges

Now, coming to the last point of disadvantages related to option trading.

If you are an active investor in the stock market, then you might be aware that the brokerage charges in option trading are relatively higher. 

So, once you place a buy order, you will be required to pay Option trading charges, including taxes, and on top of that, you will be required to pay premium and contract costs. 

The same applies to the seller as well; however, he won’t be paying premiums at all. 

Apart from this, if a buyer or writer suffers a loss in his trading deal then it won’t be a good deal for him at all. 

So, these were the pros and cons of option trading. Although the pros are positively higher but one must also be aware of the drawbacks related to it, especially if you are going to opt to form them in the investment world! 

---

In a Crux

To conclude whether to purchase, sell or hold a stock as long as possible, you should realize the organization’s business and financial status back to front and must have a transparent idea of the movement of its stocks, shares, or other securities. 

Further, not just the present situation, you must be aware of the future movements and directions in which a stock/s or that company is heading.

Making an achievement in options requires financial investors to have a decent understanding of the organization’s fundamental value, however maybe even, in particular, they likewise need to have a strong thesis about ways the business has been and will be influenced by close term factors, for example, internal operations, the sector, the rivalry, and macroeconomic effects. 

Numerous investors may conclude that options add unnecessary unpredictability to their financial lives. 

Yet, in case you’re keen on investigating the open doors that options manage — and have the constitution and the money to withstand expected losses— the option trading strategies for amateurs guide can definitely help you in limiting your drawback.

Options investors should be hyper-mindful of these things, and that’s just the beginning as there are going to many more things to come in the journey!

Wish to start Trading in Options? For that have a Demat Account.

 

More on Options Trading