Advantages and Disadvantages of Options Trading

The advantages of options trading

1. Risk Management: Put options allow hedging against a possible fall in the value of shares one holds.

2. Time to Decide: By taking a call option, the purchase price for the shares is locked in. This gives the call option holder until the expiry day to decide whether or not to exercise the option and buy the shares. Likewise, the taker of a put option has time to decide whether or not to sell the shares.

3. Speculation: The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them. If one expects the market to rise, he/she may decide to buy call options. If one expects a fall, he/she may decide to buy put options. Either way, one can sell the option prior to expiry to take a profit or limit a loss.

4. Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly. However, leverage usually involves more risks than a direct investment in the underlying shares. Trading in options can allow benefiting from a change in the price of the share without having to pay the full price of the share.

5. Diversification: Options can allow building a diversified portfolio for a lower initial outlay than purchasing shares directly.

6. Income Generation: One can earn extra income over and above dividends by writing call options against your shares, including shares bought using a margin lending facility. By writing an option, one receives the option premium upfront.

The disadvantages of options trading

1. Costly: The cost of trading options including both commissions and the bid is higher on a percentage basis than trading the underlying stock.

2. Complex Process: Understanding options trading requires great observation and maintenance.

3. Lower Liquidity: With the wide range of prices available, some will suffer from very low liquidity, making trading difficult.

4. High Risk: Options, like any financial product, obey the risk/reward ratio, the higher the potential reward, the higher the potential risk, and vice versa.

5. Time Decay: Options Trading is time-sensitive in nature and leads to the result that most options trading expires worthlessly. This is only applied to traders that purchase options.

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