What is an Option?

Options are a part of everyday life in our society. Options are all around us from simple daily household transactions to the most complicated multi-billion business deals. Automobile insurance, life insurance, professional sports contracts, real estate deals, executive stock option compensation packages and other common business deals are forms of option contracts.

Today, stock options are much more widely understood, either because of the way investors learned about stock options during the Dot Com boom, or because of the role derivatives–including options–often play in modern financial scandals. But what is less understood is that trading options is as easy as for the average trader as is trading stocks.

In fact, there are a number of good reasons why options may even be a better trading vehicle for you than stocks depending on your trading style and goals.

Let’s take a look at five reasons why options are the trade of choice for so many traders, and then look at two factors that hopefully will not be at the center of your decision to begin trading options.

 

Leverage

One of the main attractions of options trading is the leverage involved. For a small amount of capital compared to the average stock trader, an options trader can control a sizable amount of stock. Leverage also allows traders to make a significant amount of money from a relatively minor movement in price. More than any other factor, leverage is the reason why traders and investors alike include options in their portfolios. What the trader likes in the power to make bigger bets with less money, the investor enjoys in the ability to completely hedge long-term stock positions at a low cost.

Trade Up, Down, and Sideways

Options give traders the opportunity to make leveraged bets on the direction of a stock. But by using any one of a number of options strategies ranging from the simple to the complex, traders can also look to gain from a stock that doesn’t move at all. The ability to trade both direction (up versus down) and volatility (movement up or down versus little or no movement up or down) is an aspect of trading options that is often overlooked by the average options trader.

Hedge Your Stock Trades

The leverage of options makes them ideal tools for protecting or hedging a stock portfolio. For a relatively little amount of money, a trader can buy options against a longer-term long trade or investment and fully protect that long trade or investment from market risk. We have found that it is possible to fully hedge a long-only stock portfolio with only minimal reductions in overall returns compared to the un-hedged, long-only portfolio.

Commissions Have Crashed

Commissions for options traders are not as low as they are for stock traders. But if the decline in commissions for stock traders has declined in recent years, commissions for options have plummeted. The standardization of options decades ago paved the way for the growth in options trading volumes which continue to put downward pressure on commissions. The proliferation of discount online options brokers in recent years has also created the kind of competition among options brokers that should help keep option trading costs low.

Limit Risk

Traders who use options have the ability to completely control their exposure to risk. Buyers of put options, for example, risk only the amount of the premium paid up front. By contrast, a trader who sells a stock short can find him or herself deeply underwater if the position moves suddenly into the red. In a worst case scenario, a trader could be forced to cover at a level where the losses could be massive. There are a number of options strategies, from buying naked options to backspreads, which actually have a limited risk and virtually unlimited profit potential.