The advantages and disadvantages of options
Options are a very unique investment vehicle so it is important to learn the unique characteristics of options before you decide to trade them.
- Leverage. Options allow you to employ considerable leverage. This is an advantage to disciplined traders who know how to use leverage.
- Risk/reward ratio. Some strategies, like buying options, allows you to have unlimited upside with limited downside.
- Unique Strategies. Options allow you to create unique strategies to take advantage of different characteristics of the market - like volatility and time decay.
- Low capital requirements. Options allow you to take a position with very low capital requirements. Someone can do a lot in the options market with $1,000 but not so much with $1,000 in the stock market.
- Lower liquidity. Many individual stock options don't have much volume at all. The fact that each optionable stock will have options trading at different strike prices and expirations means that the particular option you are trading will be very low volume unless it is one of the most popular stocks or stock indexes. This lower liquidity won't matter much to a small trader that is trading just 10 contracts though.
- Higher spreads. Options tend to have higher spreads because of the lack of liquidity. This means it will cost you more in indirect costs when doing an option trade because you will be giving up the spread when you trade.
- Higher commissions. Options trades will cost you more in commission per dollar invested. These commissions may be even higher for spreads where you have to pay commissions for both sides of the spread.
- Complicated. Options are very complicated to beginners. Most beginners, and even some advanced investors, think they understand them when they don't.
- Time Decay. When buying options you lose the time value of the options as you hold them. There are no exceptions to this rule.
- Less information. Options can be a pain when it is harder to get quotes or other standard analytical information like the implied volatility.
- Options not available for all stocks. Although options are available on a good number of stocks, this still limits the number of possibilities available to you.