Benefits and risks
Options trading can be an effective way of generating wealth, whether as part of a wider investment strategy or as a standalone technique. The flexibility options provide in allowing you to profit from rising and falling markets, as well as the ability to simply let options expire without significant financial cost, make them powerful products.
However, options do carry risks. In particular, when writing options you can open yourself up to the risk of potentially unlimited losses.
Generate wealth from rising and falling markets
As options are classed as either call or put options, you can generate wealth from rising and falling markets. You would take a call option to profit from a rising market – locking in a buy price now and benefiting from the underlying security’s capital growth over time. On the other hand, you would take a put option to benefit from a falling market, by locking in a high sale price before values fall.
Relatively low risk
Taking options is a relatively low-risk trading strategy. If the underlying securities do not behave as you expect, you can simply allow the option to expire. The most you can lose is the initial premium you paid for the option.
Some investors use options to defer the decision to buy or sell shares, a strategy that allows you to see how the shares behave before making a commitment either way. Again, if you decide not to exercise the option, the most you can lose is the initial premium – normally only a fraction of the total share price.
Earn income from your shares
Writing options against shares you already own can provide additional income. You will generate income upfront from the premium, however, you will be obliged to deliver the shares at the agreed price if the option is exercised.
Hedge against share price falls
Options can be used to offset potential falls in share prices by taking put options giving you the right to sell your shares at a pre-set price for the life of the option, no matter how low the share price may drop.
Potentially unlimited losses
Writing options can be considerably riskier than taking options as even though your premium is fixed there is the potential to incur losses greater than that amount. For example, if the market moves against your position, your losses can escalate quickly. Writing call options if you don’t own the underlying securities is particularly risky, as you will have to provide the underlying securities if you are exercised against.
Your option might fall in value
Options have an expiry date, and as such decrease in value over time. The value decrease rate accelerates the closer you get to the expiry date. Additionally, market factors such as interest rates and market volatility can affect the value of an option.
You may face margin calls
If you are writing options, ASX may require you to provide extra security to ensure that you can meet your obligations if your options are exercised. This will require you to pay additional funds to maintain your position. If you cannot do this, your broker may close out your position and you will be liable for any resulting losses.
Options trading strategies can be complex especially if you need to take offsetting positions. Doing this can be a risk, in itself, if you do not fully understand this strategy. Before trading options you should ensure you fully understand options and their risks, and consult your broker.