Risks and Benefits of Trading Options

Options benefits

• Requires a smaller initial outlay than buying the stock

• Gives an investor time to see how things play out

• Can protect investors from downside risk on stocks they own

Options drawbacks

• Can expose an investor to unlimited losses

• Requires predicting of short-term price movements

• Margin requirements can run up trading costs

Options Basics: How to trade options

Options offer investors more strategic (and financial) leeway than they can get by simply buying, selling or shorting stocks. Traders can use options to protect against portfolio losses, snag a stock for less than it sells on the open market (or sell it for more), increase the return on an existing or new position, and lower the risk on speculative bets in all sorts of market conditions.

Yes, there are a lot of positives in the pros vs. cons of options trading. But there also are inherent risks. Here are some things every potential options trader should consider.

The advantages of trading options

It requires a lower upfront financial commitment than stock trading. The price of buying an option (the premium plus the trading commission) is a lot less than what an investor would have to pay to purchase shares outright.

The options investors pay less out-of-pocket money to play in the same sandbox, but if the trade goes their way they’ll benefit just as much (percentage-wise) as the investor who shelled out for the stock.

There’s limited downside for option buyers. When you buy a put or call option, you aren't obligated to follow through on the trade. If your assumptions about the time frame and direction of a stock’s trajectory are incorrect, your losses are limited to whatever you paid for the contract and trading fees. However, the downside can be much greater for options sellers — see the drawbacks section below.

Options offer built-in flexibility for traders. Before an options contract expires, investors have several strategic moves they can deploy, including:

• Exercise the option and buy the shares to add to their portfolio

• Exercise the option, buy the shares and then sell some or all of them

• Sell the “in the money” options contract to another investor

• Potentially make back some of the money spent on an “out of the money” option by selling the contract to another investor before it expires

Options enable an investor to fix a stock price. In an action similar to putting something on layaway, option contracts let investors freeze the stock price at a certain dollar amount (the strike price) for a specific period of time. Depending on the type of option used, it guarantees that investors will be able to buy or sell the stock at the strike price any time before the option contract expires.

The drawbacks of trading options

Options expose sellers to unlimited/amplified losses. Unlike an option buyer (or holder), the option seller (writer) can incur losses much greater than the price of the contract. Remember, when an investor writes a put or call, he or she is obligated to buy or sell shares at a specified price within the contract’s time frame, even if the price is unfavorable (and there’s no cap on how high a stock price can rise).

There’s limited time for the investing thesis to bear out. The very nature of options is short term. Options investors are looking to capitalize on a near-term price movement, which must take place within days, weeks or months for the trade/contract to pay off. That requires making two correct assumptions: picking the right time to buy the option contract, and deciding exactly when to exercise, sell or walk away before the option expires. Long-term stock investors aren’t on a deadline. They have time — years, even decades — to let their investing theses play out.

Potential traders must meet certain requirements. Before you can even start trading options, you must apply for approval through your broker. After answering a series of questions about your financial means, investing experience and understanding of the inherent risks of options trading, the broker will assign you a trading level that dictates what types of options trades you’re allowed to place. Any investor who trades options must keep a minimum of $2,000 in their brokerage account, which is an industry requirement and an opportunity cost worth considering.

Options investors may incur additional costs that affect their profit and loss results. Some options trading strategies (such as selling call options on securities you don’t already own) require investors to set up a margin account — which basically is a line of credit that serves as collateral in case the trade moves against the investor. Each brokerage firm has different minimum requirements for opening a margin account and will base the amount and interest rate on how much cash and securities are in the account. Margin loan interest rates typically can range from the low single digits to the low double digits.

If an investor is unable to make good on the loan (or if the brokerage account balance dips below a certain percentage, as can happen due to daily market fluctuations), the lender can issue a margin call and liquidate an investor’s account if he or she does not add more cash or stocks to it.

The Options Clearing Corporation provides a detailed rundown of the characteristics and risks of standardized options and an overview of U.S. federal income tax rules that affect those investing in options and other financial products.

Other considerations

To decide whether to buy, sell or hold a stock for the long term, you should know the company’s business inside out and have a clear sense of which direction the asset is heading. Options investors need to be hyper-aware of these things and more.

Options success requires investors to have a good grasp of the company’s intrinsic value, but perhaps even most importantly, they also need to have a solid thesis about ways the business has been and will be affected by near-term factors such as internal operations, the sector/competition and macroeconomic impacts.