Benefits and Drawbacks in Long Term Investments

Using stock options to invest in stocks is a good way to minimize risks and allow for higher returns from a lesser amount of money. Many small investors are able to build a solid portfolio from just a few thousand dollars and spread risk around many different stocks, as opposed to investing in just one stock. Options allow small investors to diversify and also save money when the markets are volatile.

Benefit: Leverage

Stock options allow investors the ability to leverage their positions for short term investments. For longer term, leverage is also available, but not to the same degree as short term investments due to higher premiums.

Benefit: Less Money Required

To control 100 shares through options, you will only pay a fraction of what you would otherwise to buy the shares outright. With a $2500 portfolio, you could buy very little amounts of one stock, or buy stock options for 25 different stocks.

Benefit: Limited Drops

Options never drop below a value of zero; thus, even if your strike price is $10 away from the current price, you're not holding a loss to hold onto your options. Consider this: if you bought a stock for $25 and it dropped to $15, you would have a $10 loss per share. If you bought call options with a $25 strike price and the stock fell to $15, you would only lose the premium, which would likely be around $1-2 per share. This is a huge benefit because you can hold huge losses without losing large amounts of money. The best stop loss is one that doesn't cost you any money. For volatile market conditions, options are a much better way to position yourself as even the biggest runaway trades will never cost you more than the premium.

Drawback: No Dividends

Options do not pay dividends, thus the only way to make money is through capital gains. Dividends make up a large part of some investing strategies, and therefore, this may be more damaging to some investors than others. If you're planning on building an income and a portfolio, options aren't the way to do it.

Drawback: Premiums

Options always carry a premium over their exercise value that can sometimes exceed the stock price by 5% or 10% for long term options. This makes buying options for 2 year future values rather speculative, as you would need a 10% change in the stock price in your direction just to break even. As the option nears the exercise date, they slowly lose value, causing the premium to be lost to time. Options investors often have a hard time covering the premium, which often puts the odds against an investor. This is by far the biggest drawback that options investors face when playing the stock market.

Drawback: Higher Taxes

Because options rarely trade for dates much further than 2 years out, traders pay a higher tax on their profits, as the options are rarely exercised after the tax threshold date of 2 years. Traders have to be ready to pay hefty taxes when taking a profit, but that comes with any speculative investment. Don't be blind sighted; know the tax rates and laws on trading options before you begin. Many traders are left with a fat tax bill they haven't prepared for when April rolls around. Be careful to allocate profits for taxes before they are due.