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Question By Eugene Lee
"Why Trade Options?"
Why should anyone trade options?
Asked on 16 April 2010
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Answered by Mr. OppiE
Hi Eugene,
Why trade options is definitely the simplest yet most important question to be asked in options trading. Options trading has been gaining immense popularity over the recent years. In fact, stock options trading far exceeds single stock futures trading in the US market. So, what spurred the growth of options trading and why should anyone trade options?
In essence, there are five broad reasons why options are traded and why options are so popular amongst retail traders; Leverage, Low Capital Requirement, Flexible and Rewards Smart Calculation.
Why Trade Options - Leverage
Leverage is the number one reason why options are traded in the market today. Indeed, speculative volume has always formed the backbone of liquidity in the market for all financial instruments; stocks, futures, options alike. The ability to make hundreds or thousands of percent in single trade return has been the lure for retail traders frustrated with average income and average performance in the stock market. Indeed, options has the ability to make over ten times the profit on the same stock move. For instance, if a stock moved up by 10%, an options trader could potentially make up to 100% or more in return buying call options instead of the stock itself.
Since leverage is so attractive, why trade options instead of futures?
Futures is another powerful leverage instrument which has the same potential to make over ten times the return, however, the problem with futures is that profits and losses are realised at the end of every trading day! This means that if the stock makes a temporary pullback on the first couple of days and that pullback wipes out your account, the position will be closed and even if the stock rebounds, you won't be in position to take advantage of it. Options are only closed upon expiration, giving you the power to hold on and survive temporary pullbacks. This alone puts the odds of winning in your favor trading options rather than futures. On top of that, if the pullback is strong enough, you might even end up owing money to your broker trading futures while you will never lose more than the money you use when you simply buy call or put options. Futures also have a much higher capital requirement than options, frequently requiring thousands of dollars to put on a single position.
Why Trade Options - Low Capital Requirement
This brings us to the next reason why most retail traders seeking leverage would trade options rather than futures. You can trade options as long as you have the cash to buy a single options contract. A single options contract costs anything from thousands of dollars to just tens of dollars due to the wide range of strike prices available. In single stock futures trading, you need to put forth an amount of initial margin equal to 25% of 100 shares, which typically means a few thousand dollars at least.
For instance, AAPL is trading at $247.40 today. 100 shares of AAPL stock would cost you $24,740. 1 contract (covering 100 shares) of AAPL futures would require a deposit of $6,185. 1 contract (covering 100 shares) of AAPL's front month $240 strike price call options would only cost you $1,385. See the huge difference in capital required to speculate on the same 100 shares of AAPL using the different instruments? In fact, if you go slightly out of the money to the $290 strike price call options of AAPL today, you would need only $66 for 1 contract covering 100 shares!
Why Trade Options - Flexibility
Options are extremely flexible and enables extremely precise hedging due to the fact that there are ways to adjust the exact behavorial characteristics of your options position, known as the "Greeks", to exactly suit any purpose you want to achieve. In fact, there are literally hundreds of known options strategies and countless possible combinations in options trading that enables you to profit under extremely broad or precise moves. In fact, there are even options strategies that profit in all three directions, upwards, downwards and sideways! No other derivative instruments in the world today is capable of such extreme flexibility and the ability to optimize the returns on extremely specific outlooks.
Why Trade Options - Rewards Smart Calculation
Due to the fact that options are extremely flexible and that everything from their behavorial characteristics, their risk reward profile and probability of winning can be adjusted using various combinations and strategies. As such, options become a derivative instrument that rewards smart mathematical calculations which truly appeals to the more educated and tech savvy retail traders today.
For instance, if you expect a stock to trade within an extremely narrow price channel, you could adjust the maximum profit zone to the price you most expect the stock to end up in, the breakeven points range should more volatility kicks in and the probability of win through adjusting the possible profit price range of the position by using strategies such as the Butterfly Spread or Condor Spread.
Yes, the more accurate your outlook along with the more accurate your position is calculated to fit that exact outlook, the more profitable you will be with options trading.
In conclusion, there are many reasons why people trade options and these are what I feel to be the main ones that beginners take into consideration when deciding to take their first dip into options trading.
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