Listed options are a type of derivative security that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specific date. Options are popular among traders because they offer the potential for high profits with relatively low risk.
However, traders should be aware of several disadvantages of trading listed options in Australia.
High transaction costs
Listed options have high transaction costs, which can eat into potential profits. The bid-ask spread is the difference between the price at which a market maker is willing to buy an option and the price they are willing to sell it. This spread can be significant for options, particularly those with low liquidity. In addition, traders often have to pay commissions to their brokers when they trade options.
Not all assets have listed options available on them. For example, there are no listed options on most commodities or currencies. It limits the ability of traders to use options as a hedging tool or to take advantage of opportunities in these markets.
All options have a time value, which decays as the option gets closer to expiry, known as time decay or theta. Time decay works against the option holder, so it is vital to be aware of it when trading options.
Implied volatility risk
Implied volatility is the market’s expectation of how much a stock will move over a given period. It is a critical factor in pricing options and can significantly impact profitability. However, implied volatility is difficult to predict and can change rapidly, resulting in losses for the options trader.
When an option is exercised, the option holder may be assigned to buy or sell the underlying asset at the strike price, known as assignment risk. If the underlying asset moves against the option holder, it may be assigned at a loss.
Options can be difficult to sell before expiry, mainly if they are out-of-the-money. This liquidity risk can lead to losses if the option holder is forced to sell at a low price.
Margin requirements for options are generally higher than for other types of securities because most brokers consider options riskier. The higher margin requirements can make it difficult to trade options with limited capital.
The tax treatment of options can be complex and varies depending on the type of option and the country in which it is traded. In Australia, traders may pay capital gains tax on profits from options trading.
Options trading can be emotionally charged, as it involves predicting the future direction of markets, leading to impulsive decisions and losses.
Many new traders make the mistake of over-trading options. It usually occurs when they trade too often or hold on to losing positions for too long. Over-trading can lead to significant losses and is best avoided.
In contrast, what are the benefits of listed options trading?
A few of the benefits of trading listed options include:
You can use options to hedge
You can use options to hedge against price movements in the underlying asset, meaning traders can protect their positions from losses if the market moves against them.
Options offer leverage
Options offer leverage, which means traders can control a significant position with a small capital, leading to higher profits if the trade is prosperous. However, it also magnifies losses if the trade goes against the trader.
You can trade options on margin
Traders can trade options on margin, which means they only have to put up a small percentage of the total value of the trade. It allows traders to take on more risk and potentially make more money.
You can sell options before expiry
You can sell options before expiry, which means traders can take profits or cut losses if the market moves against them. This flexibility is not available with other types of securities.
Options are liquid
Options are generally more liquid than other types of securities, which means they can be bought and sold more quickly. It makes them ideal for short-term trading.
If you are interested in trading options, you can follow this link to trade listed options online.