Diversifying your portfolio: Is options trading worth it?
April 21, 2022
8 min read
What we'll cover
The definition of options
Benefits and risks of option trading
When you should trade stock options
Trading options is a little more involved than trading stocks. You have to know some basic options lingo, for starters. And it may not appeal to the passive investor who favors a buy-and-hold strategy — although there are ways to leverage options for lengthier time horizons, so option trading can still be on the table for investors who lean toward longer-term strategies. So, is option trading worth it?
First, you have to understand how option trading works.
What are options anyway?
In simple terms, a stock option is a contract that gives an investor the right to buy or sell an underlying security at a set price (called a strike price) for a certain period of time. You’ll often hear us refer to the stock an option is based on, but that can be substituted with a different underlying security — an index or exchange-traded fund, for instance. The right to buy is a call option; the right to sell is a put option.
If you decide to buy or sell the underlying stock, that's referred to as exercising the option. However, when you hold an option, you're not obligated to exercise it. If you decide not to, then the option expires worthless.
Typically, option traders are self-directed investors, meaning they don’t work directly with a financial advisor (robo advisor or otherwise) to help manage their option trading portfolio. As a DIY investor, you’re in full control of your trading decisions and transactions.
Benefits of options trading
Trading options is one of those investment strategies that sounds like it’s only for the highly experienced pros, but with a little reading up, traders with varying degrees of experience can find the benefits of incorporating options in their investment portfolios. It just takes a little option education to help you answer the question: Is option trading worth it?
Options may be a cost-efficient way to invest. Buying individual stock shares outright typically means a larger outlay of cash. It’s possible toinvest in a call option at a fraction of what you’d pay to invest in stock shares, so the lower buy-in associated with options might give you the ability to invest in specific stocks that you otherwise might not be able to afford.
Options may offer a level of risk reduction. When investing in the stock market, there’s always a degree of risk, but options can potentially help insulate you against some of it. Let’s say you buy $5,000 worth of call contracts for a stock and your friend purchases $15,000 worth of shares of the same stock. If the stock fizzles, you’ll both lose, but you carry the smaller loss with the option contract since you have less money invested. This also leaves room for you to spread your cash to other assets, giving your portfolio more diversity.
Return ratios increase with options. If you had a chance to invest a fraction of what someone else is investing in a stock and make the same return, would you say no? That’s what option trading can offer. The smaller initial investment to buy means you can reap more of the rewards when a stock performs well.
When you invest in individual stock shares, you typically have two choices: hold or sell. With options, there are multiple strategies — including short and long calls and puts — you can use to leverage their potential in your portfolio. That’s important if you don’t want to feel tied to a particular investment, especially when the market becomes more volatile.
What are some of the risks with option trading?
It’s true options offer investors many benefits — if they didn’t, they’d have gone away long ago — but it’s important to be clear that they involve risk and are not a fit for every investor.
Option trading involves many moving parts. If you aren’t careful and prepared to stay on top of your option trades, you could lose the entire amount or more of your options investment in a relatively short period of time. This is because the very nature of options requires you to pick the direction of a stock’s movement within a specific timeframe. If you don’t sell your option or “exercise” it by that date of expiration, then the option becomes worthless, and you’ve lost your investment.
There are differing degrees of risk. Certainoption trading strategies can expose you to higher losses than others, so you need to know your limits when it comes to trying your hand at various options strategies.
Options have several potential influences. A number of factors can impact the outcome of an options trade. Everything from the condition of the underlying stock to the state of the economy, the supply and demand factors in the options market, and the volatility in the overall market — all of these things and more can affect the pricing of option contracts and therefore the overall performance of your trades.
Who should trade options?
Option trading can be a better fit for certain types of investors than others. Generally speaking, an option strategy might work better for investors who:
Are active traders and regularly follow stock market trends
Understand concepts like implied volatility and what that means for stock price movements
Don't necessarily want to be locked into owning shares of a specific stock
Want the potential to generate higher returns over shorter periods of time
Are comfortable with the risk involved to potentially lose the entire amount of their investment or more in a relatively short period of time.
Trading options can offer flexibility because they’re highly liquid investments. But they do require you to make some educated guesses about which way the market will move. Specifically, you need to be able to determine three things with some degree of accuracy:
Which way a stock's price is currently moving
How high or low it's likely to move away from the current price
When this shift is likely to occur
For that reason, option trading typically isn't for beginner investors. But like any other market concept, it's something you can learn if you're willing to do the research. Plenty of communities bring traders together to discuss things like option trading strategies. Ally Invest offers resources to help you learn more about options.
Taking the time to grow your option trading knowledge can help you find the best strategy that fits your experience, risk tolerance and goals.
When should you trade options?
Trading stock options is something that might be worthwhile for you if you have some background knowledge about how options work and you're able to be hands-on with managing your portfolio. In fact, options can sometimes be the better choice over stocks, depending on the situation:
You want to hedge your bets. Options have the potential to earn higher returns while investing smaller amounts of money. This, in turn, can allow you to limit your risk exposure across your entire portfolio.
You want to buy low, sell high. Option contracts allow you to lock in a set strike price at which you can buy or sell underlying shares. If your guess about a stock's movements pays off, you could profit by locking in a lower purchase price or a higher sale price.
You want to multiply returns. Trading stock options could produce much higher rates of return compared to trading stocks, mutual funds or other securities. The trade-off, of course, is that you run a greater risk of losing money, too.
You want to generate income. The right option trading strategies can help you create income. For example, you can write put options or use covered calls, which involve selling call options while also holding shares of the underlying stock.
When should you not trade options?
Options can offer some great benefits, but they don't necessarily have value for all investors equally. And in some scenarios, they may not make sense at all. Here are a few situations in which you might want to think twice about getting into options trading:
You're still a fairly new trader. Jumping into option trading when you haven't fully grasped the basics of stocks can be a costly mistake. It may be better to wait to start trading options until you have a little more experience in the market.
You prefer a passive investment approach. Trading options means you have to be attuned to what's happening in the stock market and keep an eye on price movements. If you'd rather do less heavy lifting when it comes to managing your portfolio, option trading may not work for you.
You have a lower risk tolerance. When done correctly, option trading can sometimes be less risky than trading stocks. But it's not risk-free, so if you can't stomach the thought of potential losses and prefer a more balanced approach to risk, options may not be a good fit.
You're investing long-term. While option contracts can have expiration dates that are several months or even several years in the future, they're not designed to be held long-term. For that, you might look to stocks, mutual funds or bonds.
Bottom line: Is options trading worth it?
Option trading can be worth it for investors who have a strong understanding of how options work and know the basic terminology and strategies. Whether option trading is worth it for you personally can depend largely on how much you know about the market, your preferred investment style and the degree of risk you're comfortable taking on.
If you decide to give options a try, consider where they fit into your portfolio as a whole. And perhaps most importantly, remember to choose an option trading platform that's low-cost and user-friendly.