Options trading is a popular form of investing that promises high returns. But like most forms of investing, options trading has its drawbacks. Therefore, beginner investors looking to get into options trading must ask the fundamental question, “Is options trading worth it?”
Before we answer the question, we must first look at what options trading is, its advantages and drawbacks, and give you a few examples. So, is options trading worth it? Let’s dive in.
What Is Options Trading?
Options trading is an investment form where you buy and sell options contracts. Options contracts are financial instruments giving the holder of the contract the right (but not the obligation) to buy or sell an asset at a specific price and within a specific timeframe. The asset can be anything from commodities and stocks to currencies and indices.
Options contracts come in two forms: calls and puts. Call options allow you the right to buy an underlying asset, while put options allow you the right to sell an underlying asset. When a trader buys an options contract, they pay a premium to the seller, who is forced to honor the terms of the contract.
Options trading is far from simple. Quite the opposite, it is extremely complex and might be challenging for beginner investors, especially for DIY investors. Now, let’s look at a few benefits and drawbacks of options trading to understand this form of investing better.
Benefits of Options Trading
We can summarize the benefits of options trading in the following points:
Risk is subjective with all forms of investing. However, options trading does incur limited risk as long as used properly. Compared to other financial instruments, such as equities, options trading is considered less risky due to the less financial commitment involved. Moreover, they’re less risky than stocks as they’re the most dependable form of hedge. Callie Cox, a U.S. investment analyst at eToro, says: “They’re more aware of the risks, so they’re more likely to hedge.”
To add more clarity, consider the following example:
Let’s say you’ve purchased a stock trading at $100. You place a stop order at $80, and the trading day ends. You expect a relatively uneventful night, but one can never be fully sure. The next morning, the company is rocked by embezzlement news, and the day opens with the stock trading at $50. Since you have a stop order at $80, the market order becomes a sell order. So you lose $50 in a few hours because the stop order doesn’t work at night.
Let’s compare the same by putting a “put.” Unlike stop orders, puts and calls work 24/7. So if you had placed a put instead of a stop order, you would have lost only 20%, compared to $50 with the stop order.
Potential for Higher Returns
Options trading does, potentially, offer higher returns. That’s because options have one advantage over other investment forms – leverage. Here is an example of why options trading offers the potential for higher returns:
Let’s say a trader believes the stock will increase from $50 to $60. They could buy 100 shares of the stock for $5,000. If the stock price increases to $60, the trader will make a profit of $1,000.
Alternatively, the trader could buy a call option on the stock, giving them the right to buy the stock at $50 within a specific timeframe. If the stock price increases to $60, the trader could exercise the option and buy the stock at $50, making a profit of $1,000. However, the trader would only need to pay a fraction of the stock’s cost upfront, which is the premium for the call option.
The leverage the option contract provides allows the trader to control a larger amount of stock with a smaller investment. However, while options trading offers the potential for higher returns, traders must note that it also comes with higher risks (more on that later).
Diversification is one way to mitigate risk in investing. While traders can diversify their portfolios in numerous ways, options are more flexible and cost-effective, making them the ideal instrument for diversification. In addition, with options trading, investors can spread the risk across different assets and market conditions.
For example, a trader who only buys stocks is highly exposed to the performance of those stocks and the overall market. However, if the trader also buys put options on those same stocks, they can protect themselves against market declines. Additionally, if the trader buys call options on different stocks in different sectors, they can diversify their portfolio and potentially profit from different market conditions.
Drawbacks of Options Trading
Like any form of investing, traders must understand the drawbacks to understand if options trading is worth it. Below are the most notable drawbacks of options trading that every beginner trader must know.
One significant drawback of options trading is the complexity of this type of trading. Options trading involves various contracts, strategies, and concepts that can be quite challenging for beginners to understand. Moreover, there’s tons of trading lingo beginner investors must know. To trade options effectively, traders must thoroughly understand the underlying assets, options pricing, volatility, and various trading strategies.
Options contracts are generally less liquid than stocks because they represent a smaller percentage of the trading market. This means that options contracts may have wider bid-ask spreads, resulting in higher trading costs for traders. Moreover, options contracts may have fewer buyers and sellers, making it more difficult to find suitable trading opportunities.
Another significant drawback of options trading is the high volatility associated with this type of trading. Volatility is the magnitude and frequency of price movements in the underlying assets on which options contracts are based. Since options contracts derive their value from the underlying assets, high volatility can significantly impact options prices and make it more difficult to predict market movements.
When market volatility increases, the prices of options contracts can become much more volatile than the underlying assets themselves. This can create a situation where the value of an options contract can fluctuate rapidly, making it difficult to make sound trading decisions. This can lead to unexpected losses and can increase the overall risk of options trading.
Another significant drawback of options trading is the commission fees charged by brokers. Options trading can involve frequent buying and selling of contracts, resulting in higher commission costs than traditional stock trading.
Unlike stocks, which you can buy and sell anytime during market hours, options contracts have specific expiration dates and strike prices. This means that options traders may need to buy and sell contracts more frequently to manage their positions, which can result in higher commission costs.
When Should You Trade Options?
Options trading can work in your favor if you’re, first and foremost, an experienced trader. Options trading is less risky than trading stocks only if you know what you’re doing. Given the time constraints with options contracts, having at least experience and background knowledge of how option contracts work is a huge plus. So if you’re ready to take the next step in your trading ventures, you should definitely consider options trading.
Is Options Trading Worth It?
As we mentioned at the beginning, there’s no simple answer to the question, “Is options trading worth it?” The likeliest answer depends on a trader’s investment goals, risk tolerance, and trading experience. Options trading can offer significant rewards but comes with high risks.
Beginner traders should carefully consider their investment goals and are advised to consult a financial expert before investing in options trading.
That said, options trading can be a lucrative form of investing for those willing to take on the risks. It offers flexibility, diversification, and the potential for high profits. However, it is a complex form of investing not recommended for beginners.
Options trading can be highly profitable if not right. But like most investing forms, it requires extensive knowledge of markets and technicalities to make it work. Nevertheless, holding a call option on a bullish stock can bring you significant profits.
Beginner traders should stay away from options trading. Why? Because options trading is a highly complex form of investing that requires extensive knowledge of markets and technical analysis. They’re much more recommended for experienced traders.
Yes, Warren Buffer does options, and he has made a lot of money implementing a hedging strategy by selling naked put options.
Well, it depends on multiple factors, including your level of knowledge in financial markets and general trading knowledge, technical knowledge, and ability to mitigate risk. Options trading can be highly profitable if done correctly. But there’s also a significant risk involved if you don’t know what you’re doing. Therefore, if you’re a beginner, options trading isn’t worth it until you gain the necessary experience.