Exchange-traded options first began trading back in 1973. Although they’ve a popularity for being dangerous investments only expert traders can understand, options could be useful to the person investor. Here we’ll have a look at the benefits offered by options and the worth they’ll add to your portfolio.

Benefits of Options

They’ve been around for greater than 40 years, but options are only now beginning to get the eye they deserve. Many investors have avoided options, believing them to be sophisticated and, due to this fact, too obscure. Many more have had bad initial experiences with options because neither they nor their brokers were properly trained in the best way to use them. The improper use of options, like that of any powerful tool, can result in major problems.

Finally, words like “dangerous” or “dangerous” have been incorrectly attached to options by the financial media and certain popular figures available in the market. Nonetheless, it’s important for the person investor to get either side of the story before making a call in regards to the value of options.

There are 4 key benefits (in no particular order) options may give an investor:

• They might provide increased cost-efficiency
• They might be less dangerous than equities
• They’ve the potential to deliver higher percentage returns
• They provide a lot of strategic alternatives

With benefits like these, you’ll be able to see how those that have been using options for some time could be at a loss to clarify options’ lack of recognition. Let’s look into these benefits one after the other.

1. Cost-Efficiency

Options have great leveraging power. As such, an investor can obtain an option position just like a stock position, but at huge cost savings. For instance, to buy 200 shares of an $80 stock, an investor must pay out $16,000. Nonetheless, if the investor were to buy two $20 calls (with each contract representing 100 shares), the full outlay could be only $4,000 (2 contracts x 100 shares/contract x $20 market price). The investor would then have an extra $12,000 to make use of at his or her discretion.

Obviously, it isn’t quite so simple as that. The investor has to select the proper call to buy (a subject for one more discussion) to mimic the stock position properly. Nonetheless, this strategy, often called stock alternative, isn’t only viable but in addition practical and cost-efficient.

Example

Say you want to buy the stock of XYZ Corp. because you think that it can be going up over the following several months. You need to buy 200 shares while XYZ is trading at $131; this might cost you a complete of $26,200. As an alternative of putting up that much money, you can have gone into the choices market, picked the choice mimicking the stock closely and acquired the August call option, with a strike price of $100, for $34. To accumulate a position equivalent in size to the 200 shares mentioned above, you would want to purchase two contracts. This is able to bring your total investment to $6,800 (2 contracts x 100 shares/contract x $34 market price), versus $26,200. The difference may very well be left in your account to achieve interest or be applied to a different opportunity providing higher diversification potential, amongst other things.

2. Less Risk (If Used Properly)

There are situations during which buying options is riskier than owning equities, but there are also times when options could be used to scale back risk. It really depends upon how you employ them. Options could be less dangerous for investors because they require less financial commitment than equities, they usually will also be less dangerous because of their relative imperviousness to the doubtless catastrophic effects of gap openings.

Options are probably the most dependable type of hedge, and this also makes them safer than stocks. When an investor purchases stocks, a stop-loss order is steadily placed to guard the position. The stop order is designed to stop losses below a predetermined price identified by the investor. The issue with these orders lies in the character of the order itself. A stop order is executed when the stock trades at or below the limit as indicated within the order.

Example

For instance, as an instance you purchase ABC, Inc. stock at $50. You don’t want to lose any greater than 10% of your investment, so that you place a $45 stop order. This order will grow to be a market order to sell once the stock trades at or below $45. This order works through the day, however it may result in problems at night. Say you go to bed with the stock having closed at $51. The subsequent morning, while you get up and switch on CNBC, you hear that there’s breaking news in your stock. It seems the corporate’s CEO has been lying in regards to the earnings reports for quite a while now, and there are also rumors of embezzlement. The stock is predicted to open down around $20. When that happens, $20 shall be the primary trade below your stop order’s $45 limit price. So, when the stock opens, you sell at $20, locking in a substantial loss. The stop-loss order was not there for you while you needed it most.

Had you bought a put option for defense, you wouldn’t have suffered the catastrophic loss. Unlike stop-loss orders, options don’t shut down when the market closes. They offer you insurance 24 hours a day, seven days per week. That is something stop orders cannot do. Because of this options are considered a dependable type of hedging.

Moreover, as a substitute for purchasing the stock, you can have employed the strategy mentioned above (stock alternative), where you buy an in-the-money call as a substitute of buying the stock. Some options mimic as much as 85% of a stock’s performance, but cost one-quarter the worth of the stock. In case you had purchased the $45 strike call as a substitute of the stock, your loss could be limited to what you spent on the choice. In case you paid $6 for the choice, you’d have lost only $6, not the $31 you’d lose if you happen to owned the stock. The effectiveness of stop orders pales as compared to the natural, full-time stop offered by options.

3. Higher Potential Returns

You do not need a calculator to work out if you happen to spend less money and make almost the identical profit, you’ll need a better percentage return. After they repay, that is what options typically offer to investors.

Example

For instance, using the scenario from above, we’ll compare the share returns of the stock (purchased for $50) and the choice (purchased at $6). For example the choice has a delta of 80, meaning the choice’s price will change 80% of the stock’s price change. If the stock were to go as much as $5, your stock position would supply a ten% return. Your option position would gain 80% of the stock movement (because of its 80 delta), or $4. A $4 gain on a $6 investment amounts to a 67% return—a lot better than the ten% return on the stock. After all, when the trade doesn’t go your way, options can exact a heavy toll: there’s the chance you’ll lose 100% of your investment.

4. More Strategic Alternatives

The ultimate major advantage of options is they provide more investment alternatives. Options are a really flexible tool. There are numerous ways to make use of options to recreate other positions. We call these positions synthetics.

Synthetic positions present investors with multiple ways to achieve the identical investment goals, which could be very useful. While synthetic positions are considered a sophisticated option topic, options offer many other strategic alternatives. For instance, many investors use brokers who charge a margin when an investor desires to short a stock. The price of this margin requirement could be quite prohibitive. Other investors use brokers who simply don’t allow for the shorting of stocks, period. The shortcoming to play the downside when needed virtually handcuffs investors and forces them right into a black-and-white world while the market trades in color. But no broker has any rule against investors purchasing puts to play the downside, and it is a definite good thing about options trading.

Using options also allows the investor to trade the market’s “third dimension,” if you happen to will—no direction. Options allow the investor to trade not only stock movements but in addition the passage of time and movements in volatility. Most stocks haven’t got large moves more often than not. Only a couple of stocks actually move significantly, and they do it rarely. Your ability to benefit from stagnation could transform the factor deciding whether your financial goals are reached or they continue to be simply a pipe dream. Only options offer the strategic alternatives mandatory to profit in every form of market.

The Bottom Line

Having reviewed the first benefits of options, it’s evident why they appear to be the focal point in financial circles today. With online brokerages providing direct access to the choices markets and insanely low commission costs, the typical retail investor now has the flexibility to make use of probably the most powerful tool within the investment industry identical to the professionals do. So, take the initiative and dedicate a while to learning the best way to use options properly. It’s the dawn of a brand new era for individual investors. Do not get left behind!