Options are often associated with risk. This couldn`t be farther from the truth if used correctly. Before we dive into some advantages, it`s important that you know exactly what an option is. Here is a guide that should help you develop an understanding of an option:
Some of the advantages of options can clearly be seen in the reasons why an individual would invest in options. One reason may be to speculate on market movements, another reason is to hedge against an existing position in an underlying stock. Anyhow, here are 5 main reasons why I still hold options in my investing portfolio.
Leverage is the ability to use a small amount of capital to control a large asset. An investor can purchase a call option which gives a pay-off similar to buying and holding a stock until it appreciates but with less capital. For example, in order to purchase 100 shares at $80 each, an investor would have to pay $8000. On the other hand the investor could purchase a $20 call option on those shares and spend only $2000. This strategy is known as a stock replacement strategy and is cost-efficient. By using leverage an investor not only has to use less capital in order to obtain a desired amount of stock, but he can invest any remaining capital that he would have used to buy the shares on the market at his own discretion.
A well-informed investor can gain a higher return by using a suitable option strategy. For example, assume that shares of company A are currently trading at $45 and an investor expects the market price to rise and reach $60 by the end of the month. Now, he can purchase these shares for $45 and hold them until the end of the month, or he can simply purchase a call option with a strike price of $55 for a premium of $3 and lock in the selling price. At the end of the month, if the market price reaches $60 as expected, the investor will exercise the call option and purchase these shares at $55 and simultaneously sell these shares for $60 on the market, thus earning a profit of $2 per share with an initial investment of $5 per share. The total return he earns by using the option strategy is 40% ($2/$5) as compared to the profit of 33% he would have earned by simply purchasing shares at $45 and holding them till the month end.
Unlike other investments where the risks may have no limit, options offer a known risk to buyers. An option buyer will not lose more than the price paid to buy the option i.e., the premium. Thus, his loss is capped. On the other hand, option writers take on potentially larger risks in return for the premium that they receive, especially the writer of a call option, who can face the risk of unlimited losses, if he is not holding the underlying asset at the time of the expiration.
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Options allow investors to protect their holdings against price fluctuations when they do not want to alter their underlying position, ie. they don’t want to sell just yet. For example, if an investor holds shares of a company that has appreciated and wants to protect his profits should the market take a down turn, he may purchase put options to lock in his profit for the future.
Options can be used in a wide variety of strategies, from conservative to high risk, and can be tailored to different outcomes than simply ‘the stock will go up’ or ‘the stock will go down’. Options can be tailor made to suit the risk appetite of investors who want to achieve different returns and have different risk tolerances. These are called synthetic derivatives. Moreover, options can be combined with other financial instruments in such a way that their payoff mimics the payoff of other financial instruments, but with less initial capital. An investor can also create a unique risk/reward structure by using different options simultaneously.
As you can see, options clearly have their benefits. There are risks with any investment. When options are used correctly, they can become a very versatile tool in an investors portfolio. When used to attempt to make extremely high returns, such as naked calls, options can produce devastating losses. It is very important to consider your appetite for risk prior to dabbling in options.
Author Bio: Dan Kent is a writer and co founder of Stocktrades.ca. A DIY investor for 7 years now, Dan has a combination of dividend, growth and real estate investments in to his portfolio and is looking to continually grow his net worth. You can check his website out at stocktrades.ca or follow him on Twitter at @Stocktrades_CA.