If you have already invested in mutual funds and stocks and want to diversify your portfolio, you may consider exploring the world of options trading. Options trading slightly differs from standard stock trading because it offers more strategic freedom. However, before diving into it, you need a thorough understanding of how options work, including their advantages and disadvantages.
Options offer an investor the right to purchase or sell a stock at a certain price before its expiration date. While such an investment tool may sound simple to beginners, performing an options trading risk analysis before investing is always a good idea.
Advantages of Options Trading
To understand whether options trading is an ideal choice for you or not, let’s take a look at the advantages this investment option has to offer.
When it comes to options trading, you get greater flexibility. Depending on the type of option and your position as a trader (buyer or seller), you can better hedge against your existing investments. This offers you additional income from your already-owned stocks. And if things don’t go as planned, you can use different strategies to adhere to your investment goals.
Lower Financial Commitment
Options trading lets you reap the benefits of stock price movements without buying the actual shares. Moreover, the potential returns are expected to be much higher than what you initially invested. Simply put, you need to spend a lot less to purchase an option than you would have paid if you bought the shares outright.
Reduced Risk for Buyers
In options trading, you can develop trading strategies that reduce your risk of making a loss, such as hedging. If things start to go south, your loss will be restricted only to the contract payment and the applicable trading fees. You are not obligated to make the call regarding buying or selling the underlying stock. You will only lose the contract premium during loss-making.
These advantages certainly make options trading an excellent choice for investment. However, it has some disadvantages as well.
Disadvantages of Options Trading
Every investment strategy, including options trading, has its disadvantages. You need to consider the following things while investing in options trading.
While options trading may initially sound simple, it comes with several complex rules. Unless you thoroughly understand the market dynamics and have mastered the trading practices, you should refrain from options trading. The high leverage in options trading can quickly reduce your funds to zero when a trade goes wrong.
Option trading aims to profit from short-term price movements within days, weeks, or even months. For that reason, traders must select the right time to buy an options contract and choose the right time to sell, exercise, or leave it before expiration. However, determining the right time for trading is often complicated since the time available for making the decision is significantly short.
It Is Not for Everyone
To receive a broker’s approval, you must fulfill a set of requirements before you can start trading options. It involves answering a number of questions asked by your broker. This evaluation allows such brokers to determine your investment experience, the financial means you would be using, and whether you know the risks involved with this kind of trading. You must deposit a minimum of $2,000 into your brokerage account.
If you are ready to deal with such disadvantages, then only you should proceed with this investment option.
Regardless of which financial product you choose to include in your investment portfolio, whether options, stocks, or derivatives, it is always wiser to understand its potential advantages and disadvantages first. Since options trading is complicated, you should not rush into it without proper knowledge.
This article Options Trading — Exploring the Advantages and Disadvantages originally appeared on Rick Orford – Helping You Invest In Yourself.