Advantages and Disadvantages of Option

To better understand options and some of the advantages and disadvantages of trading them, look at the fo1lowing example. Robert and Susan still hold divergent opinions about the market. Let's see how three different market scenarios affect their profits and losses when trading options. In these examples both intend to hold the option until it expires:

1. Robert is bullish on the market which is currently trading at 100, and he believes the future may appreciate to 120 in the next five months. He does not wish to purchase the future outright, partly because if the market drops instead of rallies he is concerned he will lose too much money. He decides to purchase a 105 call for $3 which expires in six months. The call allows him to buy the future at 105 anytime in the next six months. He would not choose to buy the future now at 105 since it is presently trading at 100. He may sell the call before it expires but feels it is better to hold on for the long term.

2. Susan is bearish on the same market but is not certain how far it might drop. She decides to sell the same 105 call at $3. If the market should rally above 105 at expiration, she will have to sell the future at 105.

Scenario 1: Market rises to 120. If Robert bought the call, how much money did he make? He exercises the call, which enables him to buy the future at 105 and simultaneously sell the future at 120. The profit is 120 - 105 = 15. But remember he paid $3 for the call so he must subtract $15 - $3 = $12. His profit is $12.

If Susan sold the call then the reverse holds true. She will be assigned the future and become short at 105. She must buy the future back at 120 to cover her sale at 105. She received $3 for the sale of the call so her total loss is $12.

Scenario 2: Market ends unchanged at 100. Robert is long the call but he would not want to exercise the option. If he exercised the option, he would effectively buy the future at 105, which would be senseless since he can buy it at the market at 100. Therefore, the call expires worthless and he loses $3 or the original price of the call.

If Susan sold the call the reverse holds true. She will make $3 for the amount received from the call sale, and it would be highly unlikely that she would be assigned the call.

Scenario 3: Market drops to 80. The same results in scenario two would apply in this scenario because the call would not be exercised at 105. If both traders decide to hold onto the option until expiration, the market would have to go above 108 for Robert to make money and Susan to lose money.

This example points out the reasons why investors buy or sell options. If the market goes strongly in your favor, as it did for Robert in scenario 1, you will make a good profit on a small outlay of cash. However, if a good move never occurs you will most likely end up losing money. Robert and Susan held the options till expiration, but what if they had decided to exit the position before then, as many traders do? The question is not always easily answered because of the various factors which affect the pricing of options.