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Options: Advantages & Disadvantages

Option - Advantages

Options: Advantages & Disadvantages
  • Flexibility - With options you can trade any type of potential move in the underlying security. Think the shares might double within a week - perhaps you believe the shares will hardly move over the next month - you can even use them to protect your downside. Basically if you have a view, you can use an option strategy to trade it

  • Gain leverage - Options can offer incredible leverage, and returns of 100% or even higher are possible. This leverage can be used intelligently. For example, options can be used to take a position in a stock using a small down payment

  • Directional choice - Obviously related to flexibility. Options are good tools for trading upward and downward and even sideways price movements

  • Reduce risk - Futures and CFDs also offer leverage but the potential losses are often open-ended. Many option strategies allow similar leveraged profit potential but with limited risk

  • Sell options against shares that you already own - This is called a covered call strategy and it's a way to earn extra income from shares you already hold

  • Can be low risk - Many option strategies involve low risk or are designed to limit risk

Option - Disadvantages

  • Can be high risk - A common misconception with options is that they are high risk. Sure, they can be as high risk as you want but many option strategies are designed to reduce risk. Options, like any financial product, obey the risk/reward ration - the higher the potential reward the higher the potential risk and vice versa

  • Leverage - It's always a double-edged sword. Leverage is great when making money but horrible when losing as it means all losses are multiplied. Most traders who suffer losses in options do so because they use too much leverage

  • Complex - It's theoretically possible to teach anyone how to buy and sell shares and conduct general business in the stockmarket within a few hours. But this cannot be done with options. A proper, solid but basic option education will take about 1-2 months at a minimum. To be a real pro will take at least 1 year. Do not forget this

  • Volume - Some options don't trade that much which in turn means there's little liquidity. If no liquidity the bid-offer spreads can be grossly wide, sometimes as much as 10%. With spreads like that it's almost impossible to make money. As a good rule of thumb, first check out the average daily volume and if it's low don't get involved with those options

  • Computers normally have to be used - Not always but it's hard to discount their usefulness when using options. If you're not that competent with computers and struggle with Spreadsheet programs like Excel that's going to be a disadvantage

  • Wasting assets - Normally a disadvantage to most people new to options because they'll often start off buying them. But options lose value over time so not only do you have to be right on direction but also with your timing. Direction is often not that hard to predict, but timing is a different story altogether

  • Unlimited risk - If you sell an option short your risk is often unlimited. Short calls have unlimited risks attached (theoretically there's no limit to how high a share can rise). The risk on a short put is limited as the underlying cannot fall below zero. But if the underlying were to fall sharply the losses on short puts can be horrendous
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  • For my personal trading I like to use Core Spread
  • Got to love their ultra low bid-offer spreads

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