Advantages and risks in options trading

Summary

 

• 
  
  Ö  It is important to understand both the advantages
  and risks involved in trading options before you decide to include options as part of your trading or investment strategy.
  
  
• Ö  A risk for a buyer of an option can often translate into an advantage for the seller of the option.
• 
  
  Ö  The main advantages from trading options are: ˜ risk management
  ˜ speculation
  ˜ leverage
  
  
  ˜ diversification
  ˜ income generation.
• Ö  Options can provide an investor with the ability to manage risks on their current portfolio by creating a hedge against a potential adverse movement in the market price of their current share holdings.
• Ö  Options provide another financial instrument that can be used by traders to generate short-term profits on the stock marke
  
  
  • Ö  Options can provide the buyer with the advantage of leverage. This gives them exposure to a similar profit or loss if they had invested in the underlying stock at its full value, for only a fraction of the market price of the underlying stock.
  • Ö  As options cost only a fraction of the price of the underlying security, you can gain exposure to a large range of stocks with a relatively small outlay compared with investing in those stocks directly.
  • Ö  Premiums from selling options can provide a means of income generation for a savvy option trader.
  • 
    
    Ö  The main risks involved in trading options are: ˜ market risk
    ˜ risk of expiring worthless
    ˜ risk due to leverage
    
    
    
    ˜ potential for unlimited losses ˜ risk of margin calls
    ˜ liquidity risk.
    
    
  • Ö  Like all financial investments, there is the risk that the market price will move in a direction that results in a loss.
  • Ö  All options have a limited life determined by the expiry date. As a buyer of options, if the market price of the underlying security does not move sufficiently in your direction before the expiry date, your option may expire worthless.
  • Ö  Leverage can magnify your losses as well as your profits.
  • Ö  As a seller of uncovered call options, you are exposed to
    the potential of unlimited losses. 
    
    
    • Ö  As a seller of put options, you are exposed to losses equal to the value of the underlying security at the strike price of the option.
    • Ö  As a seller of options, you are required to provide a margin and may be exposed to margin calls that need to be met within a short time frame (often 24 hours).
    • Ö  Lack of liquidity in the options markets, particularly in times of high price volatility, may make it difficult to close or exit an option position. 

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