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Best things about trading options

 

1) Capital Efficient - Larger Potential Profit

Buying options, the capital required will be at most the cost of the option contract, as owning an option can only go down to $0.  Because option contracts have a time component and strike component (unlike stocks), it means only option contracts will always be cheaper than owning shares.

Selling options, the capital required will be based on Margin Requirements set by the regulators and potentially adjusted by the broker.  The main difference is that initial capital required to sell options is based on formulas trying to target a probabilistic move against the position and not based on the max value the shares could become.  This generally leads to about 1/5 the capital and potentially less if the account qualifies for Portfolio Margin.

These lower capital requirements mean that options can have risk that is leveraged to the corresponding stock, meaning less capital is required to taking similar risks of buying stock shares.

2) Strategic

 Besides capital efficiency, trading options allow for much more strategic trading.  Meaning profits and losses aren't bound to making money if stocks go up or down, but also depends on timing and magnitude of movement up or down.

  • directional leverage - buying Puts and Calls

    Purchasing puts and calls for bearish or bullish trades respectively can add larger potential profit if stocks move in the large enough in the directional assumption within the given time for maturity of the option.  

  • generate income - overwrite

    Selling calls against stock shares you own.  This is one of the most popular ways to use options as it is intuitive: enhance yield by selling a defined upside.  If the stock doesn't move higher than the call strike, collect the premium.

  • hedge portfolio - put buying

    Buying put options against shares you own.  This is also one of the most popular ways to use options as it is intuitively paying a premium for downside protection (just like insurance).  If the market or stocks crash and drop below the put strike, this sterilizes those losses.  The difficult thing about put buying is that it requires judgement on when is necessary to buy and also when to monetize.

  • non-directional trading - selling puts and calls

    Selling options (calls and/or puts) can be very profitable if the option seller believes the market will go sideways.  This initially seems easy and straight forward, but with the unpredictability of short term stock prices, this can be very difficult mentally without some type of consistent process.

  • omni-directional - ratio spreads

    Since puts and calls can be used as building blocks for more complex strategies, it is very possible to make omni-directional trades.  These are trades that can be very profitable if the stock price move close to a optimal distance from the current price, but if it moves too far the trade could work against.  For example if you buy 1 put and sell 2 puts further away, the strategy will make money if the stock moves towards the 2 puts further away, but if it moves too far, it will be a losing position.

Takeaway:

As long as option markets are liquid, fare and have tight bid / ask spread, it can unlock a variety of strategies that include a time component (expiry) and a magnitude (strike).  Making it possible to create strategies that can profit any type of environment.

 

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