If you’ve ever been interested in making money on the stock market, but you don’t like the idea of “buying and holding” value stocks, or if you don’t like the idea of trading stocks conventionally, you might consider trading stock options.
Trading stock options is a strategy that relies on contracts; through these contracts, you’ll give yourself the privilege to buy or sell an asset for a specified price within a specified timeframe.
For example, let’s say Company A is trading for $100 per share currently. You believe the stock price is going to skyrocket in the next week, so you can use stock options to offer to buy 100 shares of the stock for $110 per share in the next week. If the share price does skyrocket, let’s say to $125 per share, you can capitalize on your agreement and buy shares for cheaper than the going rate.
Obviously, the mechanics of trading stock options are more complex than this; there are different types of options you can trade, and many variables to consider. But what are the overall pros and cons of trading stock options?
The Advantages of Stock Options
There are several potential benefits to trading stock options, including:
- Taking advantage of falling prices. When buying stocks traditionally, you can only benefit from rising prices. If you buy a stock at $100 per share and the stock price increases, you can sell the stock for a profit. But if the share price falls and never recovers, you’ll be stuck with the loss. Stock options give you an option to take advantage of falling prices; if you believe a stock is going to fall in price, you can use a “put option” to get the right to sell shares of stock at a fixed price.
- Hedging your bets. Some people use stock options as a way to balance the risk from their other investments. For example, if most of your portfolio is invested in long-term stocks, you might be especially vulnerable to a recession; if you’re concerned about the possibilities, you might use a put option to offset the risk, and minimize your losses in such a scenario.
- Accessing financial leverage. Stock options provide you the opportunity to take advantage of financial leverage; in other words, you can generate returns based on money you don’t initially have. Because trading options works by forming contracts, you can pledge to buy or sell assets in the future using a fraction of the funds necessary to complete that transaction in the future. If you play this correctly, you could end up making many times your initial investment, and build wealth faster than with traditional stock investing strategies.
- Utilizing volatility and timing. Ordinarily, volatility in the stock market is a bad thing. It makes investors uncertain, and can disrupt an otherwise well-planned investment strategy. However, stock options give you the opportunity to use volatility to your advantage. In a particularly tumultuous market, if you time your transaction right, you can make a substantial profit from the fluctuating prices.
- Providing additional flexibility. When buying and selling stocks in a traditional form, you’re relatively limited on what you can do. You may be able to use price limits to execute a trade, rather than relying on market prices, but trading options allows you to take advantage of far more tools and possibilities.
The Disadvantages of Stock Options
However, there are some drawbacks to consider, including:
- Technical complexity. Trading options isn’t as simple as trading stocks on the open market. Oftentimes, newcomers overestimate their ability to read technical patterns or execute trades, and they end up over their head.
- Strict time limits. When trading options, you’ll often be dealing with strict time limits. After buying a stock traditionally, you can sell it pretty much any time you like. But with an options contract, you’ll have a set period of time when you can act. If you’re not fast enough, or if you let your contract expire, you could end up losing all your potential value.
- Higher tax rates. Many investors are attracted to options because of the possibility of massive gains. But remember, if you make money this way, you’ll be paying the highest short-term capital gains tax rate; ultimately, this can compromise your total profitability.
- Unforgiving leverage. Financial leverage is an awesome tool when it’s working in your favor, but it can also work against you; if you trade with borrowed funds and lose, it could financially crush you.
Overall, trading stock options is a viable strategy you can add to your overall investment portfolio. It’s not the most complex financial strategy, but it’s something you’ll want to learn about in depth before diving in; if you’re not careful, options can work against you.
