Many stock market traders believe that the purchase of options can be a great alternative to buying stocks because options cost a fraction of the cost of their underlying stock but share the gains that the underlying stock can achieve, although conversely, they do also encounter significant losses when the under lying stock loses in price.

Advantages and disadvantages

1. Money at Risk
While the purpose of trading is to make a profit, for a variety of reasons that does not happen with all trades so it is an advantage to know the amount of money that can potentially be lost when buying stocks or buying options.

All stock market trading involves risk but the amounts of money that can potentially be lost in a failed trade can differ significantly when comparing buying shares with buying options.

For instance, when buying shares in a company with the expectation of those shares gaining in value and subsequently some unforeseen circumstance occurs which prevents them gaining in value and actually causes them to lose their value, much of the original investment can be lost unless prompt action is taken to sell the shares. Many inexperienced traders become indecisive and uncertain when to sell, with the result that they lose much more of their trading stake than necessary because of this.

However, in the first place, options cost significantly less than their underlying shares and secondly, the maximum amount of money at risk is limited to the premium, the total cost of purchasing the option when the purchase is made. And since that amount is known at the beginning, it is assumed that its loss can be tolerated by the trader in the case of a losing trade.

2. Potential returns on a winning trade
In addition to paying much less for a stock option, in the case of a winning position, a major advantage in buying options compared with buying stocks is the much greater percentage return achieved by options. Examples of this have been provided elsewhere on this Stock Market Basics website, for example, here on this recent post where it was shown that a certain MPEL option had gained 120% versus the 23.2 percent gained by the underlying stock.

To summarize, options offer the possibility of very good gains with a known and limited risk if they fail to perform.

Disadvantages

1. Losses can be rapid and proportionately greater
While options can make good gains quickly when its underlying stock rises in price, it is quite the opposite when the stock falls in price. If that happens, the percentage of loss in the option is several times greater than the percentage of loss in the under lying stock. The trader has to have the mental ability and fortitude to tolerate a big loss, sometimes a temporary loss but sometimes a total loss — but as mentioned above, any loss is limited to the amount of the purchase premium [except in the case of naked puts, which on this website we do not even think of trading]. My personal approach is to establish the amount I wish to risk and from that initiate a trading position accordingly. If the option price rises as expected I can always add additional contracts and increase my stake from a position of greater strength.

2. Options must perform within a limited time
When a position is initiated, options have a specific length of time in which to achieve their desired results — which are based on the performance of their underlying stock — and beyond that pre-established timespan they expire worthless.

3. Time value of an option decays at an accelerating rate as it nears expiration date
Part of the value of an option is the amount of time remaining until expiration and the a closer the expiration date becomes, the faster the rate of loss until it’s decaying value reaches zero near its ultimate expiration date. So just as it can provide rapid gains it can also result in rapid losses. The guidelines established on this stock market basics site recommend both preference for options of 4 to 6 months away until expiration and the sale of those options regardless of their amount of gain, no later than one month before exploration. This is done in order to recapture at least a small part of the time value that might be left in the option.

Related posts:

  1. Trading the NASDAQ Index with ETFs and Options as an Alternative to Buying Shares
  2. You Can Win or Lose When Buying Stocks, Know When to Exit
  3. For the Small Trader, An Alternative to Buying Stocks
  4. Buying Stocks or Buying an ETF (Exchange Traded Fund)
  5. Buy the Stock or Buy the Option? Risks and Rewards in Trading Options
  6. Trading Options for the Beginner
  7. The Stock Market Basics Approach to Buying Stocks

Filed under: Stock Market Basics

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