You may be asking yourself the simple question: Why should I be interested in trading options? Here is a list of seven reasons why you should consider investing in options.
1. Options offer potential for huge returns
Options offer you the potential to make a 200% even 400% return on your investment in a matter of days. Though stocks offer good returns, there is no trade in the stock market that offers the potential for such huge percentage returns over short periods of time. Last fall, for example, we have had the pleasure of enjoying option trades that realized an 400%, 800% return on our investment in just eight hours. Most months, we are involved in option trades that bring us 100% 200%, return on our investment. However, with this potential for high returns comes high risk.
2. Options can be profitable even when stocks are going nowhere
While stocks require movement either up or down to make money, options in addition to this can make money when stocks are in a holding pattern or essentially going nowhere in terms of price. When you write an option, stock neutrality can be one of your best friends. So while everyone else is watching paint dry, you can be making money.
3. Options can function as insurance
If you are holding stocks for an extended period of time and are concerned about significant price fluctuations, for a minimal amount of money you can purchase options to offset any potential losses due to price drops. Options can give you the opportunity to reap the rewards of riskier investments, while limiting your losses.
4. Options are a good add on
If you are planning to hold a stock for a number of months or even years, writing options can be an excellent way to add value to your investment without even selling your stock. Of course, you will have to chose the right option, but do it right and you can pocket most of the premiums (Cash) if not all of it.
5. Options are affordable
Another attraction of options is affordability. If you are fully invested in other areas, options can be a way to invest in stocks without having to fork over a lot of cash. At the same time, they limit your losses if the trade goes against you.
6. Options offer flexibility
While stocks can only be purchased at the current market price, options offer a variety of packages based on different Strike prices and expiration dates. Because of this unique feature, one can implement a number of different strategies and tactics to generate income.
7. Options are leverage
When you buy an option contract, you have bought the ability to control 100 stocks. It's a form of leverage and as a result, gives you the potential for significant returns.
When you buy and sell options on the options market, there are a number of inherent risks. These risks must be fully understood before you invest in Options.
Time is your enemy, if you are an Option buyer.
The major difference between purchasing stock and purchasing options, is the time factor. Where time can be your friend in a stock purchase, it is your enemy when you purchase an option. All options have an expiration date and as soon as you buy an option its value immediately begins to degrade due to loss of time. It should be noted that the time loss value increases as it gets closer to expiration.
When purchasing an option you must not only be right about the direction the underlying stock will go, but you must be right about when this move will happen. If you make a mistake in the timing, even by a couple of days, you could lose what you paid for a option.
It's all or nothing
One unusual feature of the options market is its all or nothing perspective. If the underlying stock goes opposite of what you expected, the option's value can rapidly decrease. Traders are often caught off guard by how rapidly options can lose their value. The rapid loss is due not only to the decreasing stock value, but is compounded by the loss of value due to time deterioration. The greater the movement of the stock in the wrong direction, the less likely it is to recover in the time remaining in the life of the option. Of course, on the other side of the coin, if you called the stock direction right, its easy to see your investment quickly double.
Neutrality is your enemy
When you buy an option, the underlying stock can do one of three things.
1. First it can go in the direction you believe it is going to go. If it does, then there is a good chance you will get a return on your investment.
2. The second thing it can do is go the opposite direction. If it does that, you may lose the full value of your investment if you don't see the change in direction before it happens.
3. The third thing that could happen is that the stock goes into a holding pattern. If the stock price basically stays in neutral, the price of your option could expire worthless, because of decreasing value due to time loss (This is for options out of the money, if the option still in the money there is value in the option, or by exercising the option).
In some instance, the option may lose value even if the underlying stock is going in the direction you hoped it would. This is because the value of the time loss exceeds any increase in the value of the option due to changing stock prices.
This is where stocks and options diverge significantly. Where stocks will still hold some value in neutral and declining markets, options stand to lose all their value.
Inaction is your enemy
When you buy the option, the purchase price is non refundable and you can only make a return on your option, if you either sell the option before expiration date or exercise the option. Failure to act before expiration date, means the (OTM) option expires worthless and you lose everything you invested.
Some have lost money even when their option was profitable because they failed to act before expiration date or failed to exercise their option. Some stock brokers will now automatically exercise your option and purchase the underlying stock on your behalf provided there is a profit in it for you.
This differs from the stock, though you may fail to sell a stock at its most profitable moment, it can still have some inherent value. Options out of the money (OTM) lose their value at expiration date.
Even if your stock is moving in the wrong direction, it is possible to recoup some of your losses by selling the option prior to expiration. However, you will often only get pennies on your dollar investment.
Call Options
Put Options
At the Money Option
In the rare circumstances, where the price of the stock matches one of the intervals (or is within a few cents), it is considered to be "at the money."
In the Money Option
Using our XYZ stock which is currently selling for $18.34, the nearest Strike Price would be either $17.50 or $20.00. If we decide to buy a call option and choose the Strike price of $17.50, our option is considered to be in the money. What we mean by that is that our option is already profitable. By buying this Option we have the right to buy the stock for $17.50 and can turn around and sell it for $18.34. Because of this, the Option price is higher to make up for this profitability. Though the option price is higher, it can result in a higher delta.
Out of the Money Option
Using our XYZ stock example of 18.34, if we were to buy the option with a strike price of $20,00, we are immediately in a loss position and have purchased an option considered out of the money. We have the right, but not the obligation, to buy the stock from an individual for $20 but can only sell it for $18.34. Since we are buying the option in a loss position, its value is considerably less than an "At the money" or "In the Money" option. The delta is also quite lower.
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