Characteristics, Uses and Taxation of Investments - Options: Advantages and Disadvantages
6. Their advantages and disadvantages are outlined below.
|Feature||Advantage||Disadvantage||Effect on Holder/Writer|
|Cost||Options are an inexpensive way to gain access to the underlying investment without having to buy stock||As a form of insurance, an option contract may expire worthless. This risk increases the greater the extent to which the option is out of the money and the shorter the time until expiration.||Holder may be disadvantaged due to expiry. Writer would be advantaged as s/he need not make delivery once the option has expired.|
|Leverage||Options enable investors to stump up less money and obtain additional gain.||Investors should realize that options\' leverage can impact performance on the down side as well.||Writers of naked calls are exposed to unlimited risk.|
|Marketability||Option terms trade on an exchange and as such are standardized.||Regulatory intervention can prevent exercise which may not be desirable.||Both parties to an options transaction benefit from standardized and enforceable terms.|
|Hedging||Options may be used to limit losses.||The investor may end up being incorrect as to the direction and timing of a stock\'s price and may implement a less than perfect hedge.||Both the holder and the writer may be (dis)advantaged depending upon which side of the trade they assume and the ultimate direction of the underlying security.|
|Return enhancement||Options may be used to enhance a portfolio\'s return.||The investor may end up being incorrect as to the direction and timing of a stock\'s price, rendering the attempt at enhanced portfolio return worthless.||Both the holder and the writer may be (dis)advantaged depending upon which side of the trade they assume and the ultimate direction of the underlying security.|
|Diversification||One can replicate an actual stock portfolio with the options on those very stocks.||Diversification cannot eliminate systematic risk.|
|Regulation||Terms of listed options are regulated.||Restrictions upon exercise may occur by regulatory fiat (OCC, SEC, court, other regulatory agency).||While in some cases necessary, regulatory fiat can disrupt what may be a profitable trade, affecting holder and writer alike.|
Tax Rules, LEAPS and Futures
7. Drivers of option valuation include the volatility of the underlying investment upon which it is based; the time left until expiration, the level of interest rates and the extent to which the option is either in- or out-of-the-money.
8. Option holder's choices at expiration-exercise the option, allow it to expire or sell it prior to the expiration date.