In our previous post, we covered what options trading is and how it works. If you haven’t read it yet, I recommend doing so before diving into this article.  You can read it here. Today, we’re going to explore some of the pros and cons of trading options and go into why I believe having a grasp of long-term investing fundamentals is crucial before venturing into options trading.  

Pros of Options Trading

Leverage:  Options provide investors the ability to control a larger portion of a stock with a smaller upfront investment, potentially gaining huge returns. For instance, consider this real-world scenario: One options contract represents 100 shares of stock. As of this writing, Apple (AAPL) trades at around $218 per share. If you were to buy 100 shares outright, it would set you back $21,800. However, a single options contract that expires in six months costs roughly $3,320. This significant difference highlights the leveraging potential of options.

Flexibility: Options provide a number of ways to capitalize on various market conditions. Whether you anticipate a stock’s price to rise, fall, or remain steady, there’s an options play for that. As we previously learned you can utilize “call” options to profit from upward price movements and “put” options to profit from downward price movements. You can also employ more “complex” strategies like straddles and strangles to leverage volatility whether the market goes up or down. For more information about straddles and strangles check out this article.

Risk Management: Options can serve as valuable tools for hedging against potential losses in a stock portfolio, providing a shield against downturns. Let’s say you’re holding a significant long-term position in Tesla (TSLA) and are wary of recent developments affecting the company’s stock price. To protect your long-term investment, you might opt to purchase a Tesla put option. In the event of further stock declines, the put option would offset your losses, acting as an insurance policy for your long-term position.

Cons of Options Trading

Limited Time frame: Options contracts come with expiration dates, which means you’re working against the clock and don’t have the luxury of long-term security. These contracts can range from expiring the same day to extending up to 2-3 years, known as Leap options. Typically, the longer the contract, the more expensive it is because the extra time provides a safety net if the stock doesn’t initially moved as expected. Because options do expire make sure you have a clear entry/exit strategy before purchasing them.

Complexity: Options trading can get pretty intricate, involving a deep understanding of various strategies and factors affecting options prices. While options offer flexibility, their complexity might overwhelm newcomers. It’s crucial to educate yourself thoroughly and grasp the ins and outs of options trading before investing your hard earned money. In the future we’ll discuss advanced options strategies and how to navigate them.

Dividends: When you trade options you don’t own the stock in that moment, only the options contract(s) which means you won’t receive perks like dividends. If you’re dealing with a company that pays dividends, you’ll miss out on that extra income. Stocks with hefty dividend payouts usually aren’t ideal for options trading because they tend to be less volatile, making it harder to profit from options trading if the stock price remains stable.

Losing Your Premium: As we discussed in our previous article, the premium is essentially the fee you pay for the options contract. When you purchase an options contract, there’s always a risk of losing the entire premium. However, it’s crucial to recognize that this premium also grants you the ability to control a significant amount of stock without having to invest a large sum upfront. For instance, in the Apple example, losing $3,320 through options trading is a far cry from losing $21,800 outright when buying the stock directly.

Of course, the decision isn’t always that clear-cut. As an advocate for long-term investing, it’s important to discuss why understanding long-term investing and its fundamentals is essential before diving into options trading.

Importance of Understanding Long-Term Investing: 

Before diving into options trading, I believe it’s essential to learn the basics and develop a solid foundation in long-term investing. Long-term investing emphasizes buying and holding quality assets over an extended period, giving you the opportunity to benefit from the power of compounding and to ride out market fluctuations.

• Investing Psychology: Long-term investing instills discipline and patience, key attributes that are essential for successful options trading. By mastering long-term investing principles, investors develop a sound understanding of risk management and portfolio diversification, which are equally crucial in options trading.
• Market Knowledge: Long-term investors develop a deep understanding of market fundamentals, economic trends, and industry dynamics, providing valuable insights when evaluating options trading opportunities. A solid understanding of long-term investing principles enhances investors ability to identify potential risks and opportunities in the options market.
• By understanding the market you’ll essentially have a feel for how certain companies and industries move, and once you understand that you can simplify options trading and begin to create rinse and repeat strategies that will net you positive returns over time.

Final Thoughts

Options trading offers the potential for significant profits, although like any form of investing it’s not without its risks. Before you begin trading options, it’s important to assess your risk tolerance, investment objectives, and level of experience. Additionally, a strong foundation in long-term investing principles is essential for navigating the complexities of options trading successfully.

By carefully weighing the risks and rewards, investors can determine whether options trading aligns with their investment goals and objectives. Remember, education and diligence are key to success in options trading and investing overall.