Advantages & Disadvantages of Trading Stock Options

Advantages

• Leverage: With options you can achieve a greater amount of leverage than when purchasing the underlying stock. In an example with Microsoft 'Call' options (that you'll soon read) the leverage achieved was 8 to 1. Leverage affects gains and losses equally so it's important to understand how much risk you can take on a trade and how to protect yourself against losses. The trading strategies ('PSTS') taught in this Course are going to be simple purchase of Calls and Puts. But please also realize that there are other more complex option strategies that will allow you to construct different risk profiles.

• Limited risk: A strategy with limited risk can be easily constructed. In one of our examples (in a coupe pages) with Buying Microsoft Call options when the price increased we were able to make an 86% percent return while the risk was fixed at $315. Even if the price of Microsoft collapsed and went to $10 we could of only lost the $315 we paid for the option contract.

• Going Short: There are no restrictions or large margin requirements when purchasing a Put option (discussed shortly).

• 2 out of 3: When a purchase of a stock is made there are three possible outcomes: The stock can either, (1) go UP, (2) go DOWN or (3) stay the same. An option trade can be constructed so the outcome is profitable in two of those three conditions. This is accomplished with more complex strategies like a calendar spread.

• Hedge: Options can also be used as a hedge in your portfolio. A hedge is the purchase or sale of a futures contract or other derivative as a temporary substitute for a cash market transaction to be made at a later date. The hedge position is designed to protect the investor from temporary price movements in an instrument that the investor already owns or plans to own. Usually it involves opposite positions in the cash market and futures market at the same time.

Disadvantages

• Time Decay: Options are a decaying asset. The time component of the price gradually diminishes as the option approaches expiration, at which time it becomes zero. The seller of the option wants more money for his time while the buyer wants more time for his money.

• Commission: Commission as a percent can be more significant than trading the underlying stock itself. This is something you need to watch closely as it can quickly erode profits.

• Knowing When: Just being right about the direction (of a stock) is not enough to make money when trading the options. The movement of the stock (in your desired trade direction) must happen within the specified contract period and it must also happen fast enough to offset the time decay that the asset (stock option) is experiencing.