Option transactions are financial contracts that give investors the right to buy or sell a certain asset at a certain price on or before a certain date. What are the advantages and risks of option transactions? In this article, we will explain the basic features, benefits and disadvantages of options trading.
Advantages of option transactions
Option transactions provide investors with many advantages such as benefiting from market movements, hedging, portfolio diversification and leverage effect. Here are some advantages of options trading:
- Benefiting from market movements: Option transactions allow investors to take positions according to the rise or fall of market prices. Thus, investors can make profits according to market expectations. For example, if an investor thinks that the price of ABC stock will increase, he can buy a call option on ABC stock. Thus, when the price of ABC stock increases, he can exercise the option to buy the stock at a lower price and sell it at a higher price.
- Hedging: Option transactions offer investors the opportunity to protect their assets against loss of value. Thus, investors can limit or prevent possible losses. For example, if an investor owns XYZ stock but is worried that the price of the stock will drop, he or she can purchase a put option on XYZ stock. Thus, when the price of XYZ stock falls, one can sell the stock at a higher price by exercising the option.
- Portfolio diversification: Options trading gives investors the opportunity to diversify their portfolios across different asset types, markets and strategies. Thus, investors can spread risk and increase return potential. For example, by purchasing both gold and dollar call options, an investor can profit from increases in both gold and dollar prices.
- Leverage effect: Option transactions allow investors to open a large position with a small capital. Thus, investors can make more profits by taking advantage of the leverage effect. For example, an investor can buy a call option on 10 ABC shares with $100. If the price of ABC stock increases by 10 TL, the investor's profit will be 1000 TL. In this case, the investor's leverage ratio is 10.
Risks of option transactions
Option transactions, in addition to the advantages mentioned above, also bring with them some risks. Here are some risks of options trading:
- Loss of time value: Option transactions are rights that can be exercised until maturity. Therefore, the value of options decreases over time. This is called time value loss. Loss of time value can negatively impact the price of the option. For example, when an investor buys a call option on ABC stock for $1, the option has a maturity of 6 months. If the price of ABC stock does not change, the price of the option will decrease over time. At expiration, the price of the option goes to zero.
- Volatility risk: Option transactions are subject to fluctuation in market prices. This is called volatility. Volatility can both increase and decrease the value of the option. For example, when an investor buys a call option on ABC stock for $1, the price of ABC stock is $10. If the price of ABC stock rises to $12, the value of the option increases. However, if the price of ABC stock falls to $8, the value of the option decreases.
- Liquidity risk: Option transactions are carried out in a liquid market. However, in some cases, options can be difficult to find buyers or sellers for. This is called liquidity risk. Liquidity risk can affect the price of options or prevent the investor from closing his position. For example, when an investor buys a call option on ABC stock for $1, there are enough buyers and sellers in the market. However, if market conditions change, the demand for options may decrease or the supply may increase. In this case, it may be difficult for the investor to sell or buy his option at the desired price.
Conclusion
Option transactions are financial instruments that provide many advantages to investors. However, options trading also involves some risks. Therefore, investors should thoroughly analyze market conditions, options features and strategies before entering into option transactions.