The technology boom of the past couple of decades has given the average trader access to a much wider range of financial products than ever before. One of the most popular products the average investor can now trade in is stock options.
The state of the digital world now is such that every time a big-name stock moves 2 or 3 percentage points, there are traders on Twitter trumpeting how they doubled their money or more on the movement via options trading. While trading options can be very profitable, it's also extremely risky. Here’s a look at some of the pros and cons associated with option trading.
- If you want to bet against a stock, buying put options limits your potential losses to 100 percent; short-selling, on the other hand, leaves you exposed to potentially limitless losses.
- Options provide leverage, as well. By buying options instead of the underlying stock represented in the option contracts, a trader can theoretically generate the same amount of profit over time with a much smaller up-front investment.
- Options can also be used to set up complex volatility- and time-sensitive trades. Stocks essentially give the trader two choices: buy or sell. By buying and selling a combination of different puts and calls at different strike prices and expiration dates, an options trader can construct a much more sophisticated trade.
Related Link: What Is An Options Sweep?
- Probably the single biggest con to options trading is time: stock options contain a time value that is constantly decaying. A stock buyer has an indefinite amount of time to be right on his or her thesis. An options trader, in contrast, must be -- by expiration deadline -- on the money in order to profit.
- Given that, it's not surprising that a large percentage of options expire worthless, while stocks very rarely go to zero.
- In addition, except in very rare circumstances, profits are taxed at the top short-term gains rate. Commissions, especially on weekly options, tend to me much higher for options than for stocks.
- Leverage swings both ways. While it serves as an advantage when investors are correct, option traders can really take a big hit when wrong.
There’s no simple answer to the question of whether option trading is better or worse than stock trading. The most important part of the equation is that traders are educated and understand what they are getting themselves into.
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