Is Option Trading Worth It?
Yes, options trading is very much worth learning as it is a tool even Warren Buffett used.
Whether you are an investor or trader, your main objective is to make money. However, your secondary goal is to do this with the involvement of minimum risk.
The major difficulty that the new traders face is the understanding of option trading and how to use this to accomplish their goals. The concept of risk is very clear in options trading unlike in stock where you buy-and-pray for the best.
Options trading is very different from stock trading. The simple concept is everyone buys something and wants to sell later at a higher price to make profits. However, options trading is somewhat different and, option prices don’t always behave as expected. So, if the traders don’t have complete knowledge, it can lead to unexpected losses.
What Are The Options?
In simple words, options are the contracts that give you the rights (for American options) to sell or buy security. I said, “Right,” not the obligation.
It means you are purchasing the option to sell or buy security. Let’s take an example.
|$5 stock XYZ. Buy Call Option of $5 @ $5||Cost: $500 (100 shares default)|
|Positive Case: Price is $50 at expiry||
Profit excluding commission: $4,500
900% Loss from your $500
|Negative Case: Price is $4 at expiry||
Loss excluding commission: $500
You want to buy 100 shares XYZ stock for $5 per share. Now there can be two cases; either you don’t have money at that time to buy that much, or you are worried that the price may drop.
So, in such a situation, you purchase the option to buy $5 per share for $5000. After buying the option, now you have the right to buy stocks of XYZ for $5 per share. This contract lasts about a month, and it doesn’t matter what the share prices do.
Now suppose a few days later XYZ company announces that they have invented the machine that can solve world hunger and their earnings increase than before. Overnight, the stock shoots and price of the share increase from $5 to $50. Now you can exercise your option and it is now worth $4,500 in profits.
Now let’s suppose the opposite of this happens. The XYZ Company declares bad news and goes under $5 at expiry. What will happen? The option is worthless (though you can usually adjust if time permits). In this case, if your option expires worthlessly, and it will only cost you $500.
Are Options Trading Risky?
Once you are familiar with the basics of options trading, now look at the risks behind it. However, the main issue is all the options not carry the same risk. If you are a seller, the risk will be different than if you are a buyer. Look at the few terminologies used in the options trading.
When you have bought a call, you have the right to purchase the stock at a specific price. In this case, the upside potential is limited, while the downside potential is the premium that you have spent. You want the price to go up as much as it can so that you can purchase it at a lower price.
When you buy a put, it means you have purchased the right to sell a stock at a specific price. In this case, the upside potential is the difference between share prices. Again the downside potential is the same as in call holders and depends on the premium that you have spent. In this case, you want prices to go down so that you can sell at a higher price.
When you sell a call, it means you are selling the right to purchase to someone else. In this case, downside potential is unlimited and the upside potential in the premium for the option. As writers of call options, you want prices to stay the same or drop a little bit so that whoever purchases your call can’t force you to sell your option.
When you sell a put, it means you are selling a right to sell to someone else. In such cases, the upside potential is the premium for the option. While the downside is the amount, the stock is worth it. In this case, you want prices to stay higher than the strike price so that a buyer can’t force you to sell at a higher price than the worth of the stock.
Using Options to Offset Risk
There are lots of options strategies that can play their part to protect against the risk. Have a look at the few strategies.
- Covered Calls
However, it is the simplest and easy strategy, but you can’t consider it useless. It can protect you from the risk of small price movements. It can make interim the sellers by providing them the proceeds. In this strategy, the risk comes when you exchange proceeds, you are giving your potential upside share to the buyer.
It is a risk management strategy, and investor employs this to guard him against the loss of owing an asset or stock. It offers the investor to buy a put option for a fee that is called a premium.
In this strategy, the trader assumes that the cost of the asset will decline in the future. However, protective put is used when an investor wants to hedge against uncertainty and potential losses.
You can place protective puts on the commodities, stocks, and indexes; in return, it gives you some protection to the downside. It acts like an insurance policy and benefits you when the price of asset declines. There are some more complex options as well to offset risks, but those options require a bit more calculation.
Is option trading worth it? Yes, option trading is very much worth it. So, if you research before buying options, it is no longer riskier. Moreover, if you want to earn fast profits, then there can’t be anything better than options trading. If you are hesitant to try options trading, then it might be because of the risks associated with it. There are different types of options trading, and the risk levels associated with them are also different. Options trading involve lots of strategies that can help to reduce the risk of trading options. What makes option trading worth it? It is the profit potential that makes it worth it.
Sky Hoon. Read Full Bio
Website Owner, Twitter-er
He has been trading since 2008. He started this blog to share the journey about option trading. He dabbled in stocks, bitcoin, ethereum (in Celsius Network), ETF (lazy Dollar Cost Averaging) and also built websites for fun. He used this as a platform to share my experiences and mistakes in trading, especially options which I just picked up.