4 Advantages of Options (2024)

Options trading has become very popular in recent years thanks to low-cost electronic trading, improved pricing models, and online analysis tools. They offer unique advantages like portfolio protection and additional income when used judiciously. This article explores how options work and the four major advantages they have for individual investors.

Once considered complex and risky investments only suitable for expert traders, listed options have become increasingly accessible to ordinary investors. Even after options started trading on exchanges like the Chicago Board of Options Exchange in 1973, they were for decades still viewed as too complicated, opaque, and costly for the average investor to understand and utilize effectively. However, all that has changed. According to the Options Clearing Corporation, the central clearinghouse for all listed options on U.S. exchanges, about a quarter billion options were traded in 1993. Jump ahead 20 years, and there were 4.2 billion options traded in 2013. Five years later, there had been an increase of about 24%, to 5.2 billion. By 2023, the number of options traded was about 10.2 billion, just about doubling through and past the pandemic period. The four advantages below offer some reasons why this has been the case.

Advantages of Options

Though they have been around for centuries, options are only now gaining the wider attention they deserve. Many investors have avoided them, thinking they are too difficult to understand. Many more have had bad initial experiences with options because neither they nor their brokers were properly trained to use them. Like any tool, improper use of options can lead to major problems.

Words like "risky" or "dangerous" have also been incorrectly attached to options by the financial media and certain popular figures in the market. However, we can quickly demystify options here, and you can see if the options are viable and strategic vehicles for reaching your investment goals.

Options trading offers diverse strategies to suit almost every market scenario. Traders can optimize their positions by buying or selling calls (the right to buy) and puts (the right to sell), aligning with their market expectations, whether bullish or bearish. Individual investors should develop subtle strategies, often involving combinations of several puts and calls. For instance, traders might buy call options when the market shows upward momentum and the buying volume is moderate. Conversely, they might buy put options during market downturns when buying volume is subdued, benefiting from the increase in value as the market declines. Besides these strategies, traders frequently blend long and short options. These can be useful for capping potential losses, as they define the maximum risk involved.

While this can appear complicated quickly, the point is that investors can use options for insurance, leverage, and more, which is why they've grown in popularity. Here are four key advantages options offer:

• They can provide increased cost-efficiency.
• They can be less risky than equities.
• They can, at times, deliver higher percentage returns.
• They can offer investors strategic alternatives.

Let's look into these advantages one by one.

1. Cost-Efficiency

Options have great leveraging power. As such, an investor can obtain an option positionmuch likea stock position but at a huge cost savings. For example, to purchase 200 shares of an $80 stock, you would have to pay $16,000 (leaving fees aside). However, if you purchase two $20 calls (with each contract representing 100 shares), the total outlay would be only $4,000 (two contracts times 100 shares per contract, then times the $20 market price). You would then have $12,000 left to use at your discretion.

Obviously, it is not quite as simple as that. The investor has to pick the right call to purchaseto mimic the stock position properly. However, this strategy, known as stock replacement, is not just viable but also practical and cost-efficient.

Example

Suppose you wish to purchase the stock of XYZ Corp. because you think it will go up in the next few months. You want to buy 200 shares while XYZ is trading at $131; this would cost you $26,200. Instead of putting up that much money, you could have gone into the options market, picked the option mimicking the stock closely, and bought the August call option, with a strike price of $100, for $34.

You would need to buy two contracts to acquire a position equivalent in size to the 200 shares mentioned above. This would bring your total investment to $6,800 (2 contracts x 100 shares/contract x $34 market price) instead of $26,200. The difference could be left in your account to gain interest or be applied to another opportunity providing better diversification, among other possibilities.

2. Reduced Risk (If Used Properly)

Options are a dependable form of hedge, and this can make them safer than stocks. When an investor purchases stocks, a stop-loss order is frequently placed to protect the position. The stop order is designed to stoplosses below a predetermined price identified by the investor. The problem with these orders lies in the order itself. A stop order is executed when the stock trades at or below the limit as indicated in the order. However, when there's high market volatility or gap openings (when the stock price opens significantly higher or lower than the previous close), stop orders may be triggered. The stock may trade past the stop price, leading to larger-than-expected losses.

By contrast, options provide more control. Buying a put option, for instance, you can set a definitive floor for potential losses, as the investor has the right, but not the obligation, to sell the stock at a predetermined strike price, no matter how low the market price of the stock drops.

Example

For example, you buy ABC, Inc. stock at $50. You do not wish to lose over 10% of your investment, so you place a $45 stop order. This will become a market order to sell once the stock trades at or below $45. This order works during the day but may lead to problems at night. Say you go to bed with the stock having closed at $51. The following day, when you wake up, your phone buzzes with breaking news on your stock. The company's CEO has been lying about the earnings reports for quite some time now, and there are rumors of embezzlement. The stock is expected to open down around $20. When that happens, $20 will be the first trade below your stop order's $45 limit price. So, when the stock opens, you sell at $20, locking in a considerable loss. The stop-loss order was not there for you when you needed it most.

You might not have suffered the catastrophic loss if you purchased a put option for protection. Unlike stop-loss orders, options do not shut down when the market closes. They give you insurance 24 hours a day, seven days a week. This is why options are considered a dependable form of hedging.

Also, as an alternative to purchasing the stock, you could do a stock replacement, where you purchase an in-the-money call instead of purchasing the stock. Someoptions mimic up to 85% of a stock's performance but cost one-quarter of the price of the stock. If you had purchased the $45 strike call instead of the stock, your loss would be limited to what you spent on the option. If you paid $6 for the option, you would have lost only$6, not the $31 you'd lose if you owned the stock.

3. Higher Potential Returns

You don't need a calculator to determineif you spendless money and make almost the same profit, you'll have a higher percentage return. When they pay off, that's what options typically offer to investors. Let's look again at their leverage effect. When you buy an option, you're paying for the right, but not the obligation, to buy or sell an asset at a specific price within a certain time frame. This allows you to control a larger amount of the underlying asset with a relatively small investment, the option price. For instance, if a stock goes up in price significantly, the value of a call option can increase several times over, resulting in a substantial return relative to the initial cost of the option.

Example

Using the scenario above, let'scompare the percentage returns of the stock (purchased for $50) and the option (purchased for $6). Let's saythe option has a delta of 80, meaning the option's price will change 80% of the stock's price change. If the stock goes up to $5, your stock position would provide a 10% return. Your option position would gain 80% of the stock movement (because of its 80 delta), or $4. A $4 gain on a $6 investment amounts to a 67% return—much better than the 10% return on the stock. Of course, when the trade doesn't go your way, options can exact a heavy toll: you can lose 100% of your investment.

4. More Strategic Alternatives

The final major advantage of options is they offer more investment alternatives. Options are a very flexible tool. There are many ways to use options to recreate other positions. We call these positions synthetics.

Synthetic positions give investors many ways to attain the same investment goals, whichcan be very useful. While synthetic positions are considered an advanced topic,options offer many other strategic alternatives. For example, many investors use brokers whocharge a margin when an investor wants to short a stock. The cost of this margin requirement can be prohibitive. Other investors use brokers whosimply do not allow for the shorting of stocks, period. The inability to play the downside when needed virtually handcuffs investors and forces them into a black-and-white world while the market trades in color. But no broker has any rule against investors buying puts to play the downside, and this is a definite benefit of options trading.

Options allow the investor to trade not only stock moves but also the passage of time and changes in volatility. Most stocks don’t have large moves most of the time. Only a few stocks actually move significantly, andthey do it rarely. Your ability to take advantage of stagnation could be the factor deciding whether your financial goals are reached or remain simply a pipe dream.

Options strategies can be tailored for different market conditions and risk appetites. Strategies like buying calls in anticipation of a stock’s rise or buying puts when expecting a stock’s fall can lead to significant profits if the market moves as you expected. Advanced options strategies like spreads, straddles, and strangles can be employed to capitalize on high or low market volatility.

How To Start Trading Options With My Broker

Getting started with trading options through your online broker is pretty straightforward. Here are the key steps:

1. Make sure your brokerage account allows options trading privileges. Some brokers require you to apply for options approval based on your experience level specifically.
2. If required, request options approval for your account. You may need to submit some background information or take a short quiz about options risks. You may also need to simultaneously apply and be approved for margin trading on your account.
3. Review available educational resources from your broker or elsewhere on options trading fundamentals or consider virtual trading platforms to practice first if brand new to options.
4. Fund your account with enough cash to purchase options contracts and cover any future obligations they may create. Be aware of margin requirements, too.
5. Use your broker’s options chain search tools to find and analyze options contracts to potentially buy or sell based on your chosen strategy and expectations.
6. Place opening orders to purchase contract options you want to buy or sell/write contracts to open short positions at your preferred strikes and expirations. Be aware that fees and commissions may apply.
7. Monitor your options trades closely and understand tax implications for later. Adjust or close positions before expirations based on your trading plan.

The Bottom Line

With online brokerages providing direct access to the options marketsand very low commission costs, the retail investor now has the ability to use a very powerful tool to mitigate risk and leverage gains. Their benefits include cost efficiency, lower risk, higher potential returns, and providing strategic alternatives.