When you buy stock, your gain depends only on the price when it goes up. But options may provide potential benefits if a stock rises or falls. That means you can speculate on the future price of a stock, whether it goes up or not.
Leverage means you may be able to use less money to gain exposure to a stock’s price movement. In other words, with options, you gain market exposure that’s similar to owning a stock. Still, you generally commit less money to make that happen, which could mean more flexibility for you and your portfolio.
Hedging is about reducing risk. You make trades based on your best judgment; then options can help protect those trades — or your overall portfolio — if things don’t work out quite as planned
4. Income generation
One of the biggest reasons some investors trade options is to produce income. Much like a dividend on stock, options can be used to help generate an income stream. Some options strategies let you collect money on your existing or future stock positions.
Common Mistakes You Do in Options
The first mistake is having unrealistic price expectations, leading to buying options that aren’t likely to be profitable.
Imagine a stock whose price has been trending up. Traders who overestimate how much the price of that stock will rise may be tempted to buy well out-of-the-money call options. After all, these options appear to be inexpensive. But the stock price must move past the strike price plus the premium paid, fees, and commissions for the trade to be profitable. That could be a tall order.
A second common mistake involves time—traders may buy far too little of it. In other words, they believe options with expiration dates are too short.
This can be a problem because the value of an option declines as its expiration date approaches, due to what’s known as theta, or time decay. This decline is not linear; it’s exponential. As expiration gets closer, the rate of decay speeds up dramatically.
One of the advantages of options is that they use leverage, letting traders gain exposure to a stock’s price with less money than it would take to buy the stock outright. But leverage is a double-edged sword. It’s possible to make a lot of money using it, but it’s possible to lose a lot.
That’s why it’s essential to manage risk properly and why it’s an excellent idea to right-size your options positions. Owning too many options can tie up your capital and expose your portfolio to a more significant loss if things don’t go as you hoped.
Price. Time. Quantity. Understanding these critical components of options trading can help you avoid common pitfalls. And that, in turn, can make you a better-informed investor.
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