Pros and Cons of Option Trading

 

Most things in life have come with a mix of good and bad. Similarly, there are many pros and cons when it comes to option trading.

The pros of option trading include position flexibility, income generation, lower capital, asset class diversity, risk management, numerous strategies, situation, data and market condition diversity. The cons of option trading include learning time, time decay, complexity and lower volume. 

The Pros of Option Trading

The pros of option trading definitely outweigh the cons as you’ll see in this post. Some of the many pros of option trading can be found below.

Lower Trading Capital

Unlike the expenditure required to purchase a stock outright, you can finance an identical option position for a fraction of the cost of buying a stock or ETF. If you buy one-month, at-the-money (ATM) call options, your upfront cost is only 2% to 10% of the stock price, depending on how volatile the underlying stock is.

Similarly, a ‘stock replacement strategy’ is enacted by purchasing in-the-money (ITM) call options. If the stock price is $100, you can often replicate the position with an in the money or ITM call option that has a strike price of $60, for example. The option has an embedded exercise value of $40 and it will track the movement of the underlying without having to part with the entire $100.

Defined Risk 

When you purchase call or put options, your maximum loss is the premium paid. Take a $10,000 stock position for an example. If the stock price declines by 20%, you just lost $2,000. But if you replicated the position with call options at 3% of the stock price your maximum drawdown is $300.

Risk Management with Options

When volatility spikes, option trading is a great way to hedge your downside. Back in March of 2020, before the S&P 500 staged an epic comeback over the subsequent months, the U.S. equity benchmark was down roughly 35%. For a $10,000 investment, that’s a decline of $3,500.

Conversely, if you purchased three month index put options in February at a cost of roughly 5% of the SPDR S&P 500 trust’s price, your downside would have been limited to the cost of the options (5%).

Furthermore, as volatility spiked, pushing the VIX above 80, the position was likely worth more than the initial investment. Thus, you could have potentially liquidated your holdings at a loss of less than 5%.

Have a look at the table below to clearly see the pros of option trading in a position example for BGN:

BGN Value: Stock % Decline: Total Gain (Loss):
Stock Only Position: $10,000 35% ($3,500)
Put Option Only Position: $500 35% $3,000
Put Option (20% ↑ Volatility): $500 35% $100
Stock + Put Option Position: $10,000 35% ($400)

Higher Returns with Lower Risk

Because options are a leveraged play on the underlying, your returns are magnified on the upside. If a call option costs 5% of the stock price, a 1% increase in the underlying asset generates a 20% return on the option position.

Better yet, you don’t suffer the same consequences on the downside. If the stock plunges, you only lose the premium paid. Conversely, if the stock moves in your favor, your gains are compounded.

Income Generation from Options

When markets are flat or lacking direction, option trading is a great way to increase your stock portfolio yield. For example, when you own a stock, you can sell call options and generate a cash inflow. The popular but basic ‘covered call’ strategy is advantageous because it is simple yet can increase your immediate return while offering some downside protection from owning stocks outright.

Options are Universal

Whether you prefer stocks, ETFs, bonds or commodities, option trading is available across nearly all asset classes. They all come with the same benefits as the stocks or ETFs, but you can tailor your positions to assets that you’re most comfortable trading. While not all securities have options, most high volume stocks and ETFs do.

Evergreen Option Trading Strategies

Once you become familiar with option trading, the strategies are evergreen so you can use them over and over. Unlike accounting and macroeconomic analysis,  where you have to stay on top of the latest developments, option trading strategies are like tying your shoes: once you learn them, you can use the same option trading strategies for life.

Benefiting from Advanced Option Strategies

As you climb the option trading ladder, you’ll move from beginner strategies (like covered calls) to more advanced strategies (like butterflies). The math is a little complicated, but a long call butterfly involves buying and selling four different call options (total) with three different strike prices.

You can’t lose any more than the net-premium paid and the strategy outperforms during periods of low volatility. For a detailed breakdown, have a look at our Free Butterfly Trading Ebook. For more advanced traders, consider our Butterflies & Long Condor Mastery Course.

Option Trading Communities

If you lack confidence when it comes to option trading, understand, there are plenty of aspiring traders in the same position as you. From support groups to online chatrooms, there are communities of online traders that can help grow your game.

If you’re interested in one-on-one coaching and support, consider our Private Power Start Program.

Paper Option Trading

Paper trading is the best way to learn how to trade options. By honing your skills using virtual money, you can see how markets behave on a daily basis.

Nothing enhances your skills like real-life experience. And option trading with paper money will give you an opportunity to learn how to trade options without any risk. This is done by simply using the demo mode at your online broker. 

Option Strategies for All Conditions

Many investors hold off buying a stock when earnings or other uncertainties are forthcoming.  Not only this, but investors may wait to put capital to work until market direction is more clear. This can, unfortunately, end up lasting for months or even years. When this happens, both inflation and opportunity costs eat your investment capital.

With option trading, uncertainty can actually be an advantage since it increases option prices!

Not only this, but particular option trading strategies are ideal for certain situations. For example, I teach the option strategies that are best for earnings season in my Earnings Game Plan Course. Other strategies are best for bear markets.

There is an option strategy for all market conditions and situations. This advantage simply can’t be found when owning stocks and ETFs alone.

Less Reliance on Market Direction

When it comes to stocks and ETF’s, the strategies are to go long, or go short. This means a trader needs to be right about market direction. With options spreads, however, you can be wrong even when you’re right, as I frequently remind my trading community members.

Option Data

Options come with an arsenal of reliable data that option traders can use to their advantage. The option volume around a particular strike is one example of useful option data.

Option data is so helpful, in fact, that many investors and traders use options to predict stock prices.

The Cons of Option Trading

Here are some disadvantages of option trading as outlined below.

Learning Advanced Option Strategies

While beginner strategies are easily understood and implemented, advanced strategies require more dedication. If you’re option trading spreads (two options) or employing more advanced tactics like butterflies and condors (four options), understanding the risk/reward math can get a little tricky.

This is why it’s best to work with an expert trading mentor and have the support of an option trading community.

Option Time Value Decay

Because options have finite lives, the value of an option declines as time lapses. For example, if an option expires in one month, option sellers include a time value component (Theta) that’s embedded within the option premium. As the hours tick toward expiration, the component eventually ‘decays’ to zero.

Options even lose value over the weekend when the markets are closed!

As we teach at Power Cycle Trading, while this is a disadvantage to option buyers, it can be a big advantage to option sellers, especially when option spreads are constructed to take advantage of this powerful paradigm.

Beginner Option Trader Mistakes

Because option trading is a cost-effective way to gain exposure to an underlying asset, traders tend to rush in and overlook important variables that affect option pricing. The ‘Greeks’, Delta, Gamma, Vega, Theta and Rho, all influence option profitability and cannot be taken lightly.

Without understanding the mechanics of how they work, traders are sometimes confounded when their option position lags the performance of the underlying asset. Traders who take the time to learn how to trade options can, however, turn to Greeks into a pro instead of a con!

Lower Option Volume 

The option market is less liquid than the stock market. Because of this, analyzing volume, or the number of option contracts traded for a given expiration date, isn’t enough. You need to pay attention to open interest. The metric tallies the number of option contracts that are ‘open’ and yet to be exercised.

Understanding open interest is extremely important because it’s more profitable to sell an option (and capture the remaining time value) than it is to exercise. Thus, you want to ensure that there are enough counterparties willing to take the other side of the trade.

Summary

When analyzing the pros and cons of option trading, there is definitely a lot to like.

The safety net of defining your downside allows you to speculate on short-term price movements while still preserving all of the upside. Moreover, buying options has a positive skew. In statistical terms, this means you’ll lose a small amount of money most of the time and make a large amount of money some of the time.

The trade-off is extremely beneficial because you only need a small number of trades to pay off to have a profitable month or year.

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