There is a multitude of ways for making money from stock market. Among those, the most popular and less risky one is trading and investing in stocks. In fact, the majority of the trading education courses focus on the strategies for successful stock trading. So, why are people not clamoring for the highly rewarding Futures or Options Trading? Despite the high returns from Options, there are quite a few drawbacks which make them a riskier investment. Read on to know why trading Options is not for the faint of heart!
What is an Option? An option is basically a contract between a seller and a buyer to sell or buy a security at a specified price within a specified time period. Each option contract typically represents 100 shares of a stock. The specific price of buying or selling the underlying security is called as a strike price and the date till which the contract can be held is called as the expiration date. Typically, the expiration date for an option is three months, six months, or nine months.
There are two types of options – call and put options. A call option gives the buyer the right to buy the shares at the specified price. It is usually used for income generation, tax management, and speculation. A put option gives the buyer the right to sell the shares at the specified price.
In case you are bullish on the market, you can either sell a put option or buy a call option. Alternatively, if your market outlook is bearish, you can sell a call option or buy a put option.
The advantage of Options over stocks: The biggest advantage that options have over stocks is the use of leverage. This makes them quite cheaper when compared to purchasing stocks. You can take advantage of the up or downward movements of the stock by investing just a little money.
Why are Options risky? Buying options are less risky as your losses are limited to the money you paid for buying the option. However, if you sell options without owning the underlying stocks, you may be exposed to unlimited losses. The margin requirements of your brokerage firm will also be quite stringent if you opt for naked call writing.
This risk is best explained with an example. Assume that you sell a call option with a strike price of $50 with the expectation that the stock price will decrease. But if the price increases to $60 or $70 at expiration, you will need to buy back the stock at this increased price and sell it to option buyer for $50, incurring huge losses.
Covered call writing strategy can be used instead of selling naked call options if you already own shares of the underlying stocks of the option.
Attending good trading education classes from experts in the field would be usually enough to make profits in the case of stock trading. However, Options is a whole different ball game. It is always best to venture into options trading under the guidance of an experienced professional first before you try it out on your own.