If your relatives think you're crazy for trading stocks, wait until you tell them you've opened an options account.
Options have come along way from the heady days of the late 1960s, before standardized pricing and mathematical pricing models were commonplace. As with the early days of futures markets in those same years, trading options back then was the closest thing on Wall Street to being a gold miner in '48 San Francisco--or a horsetrader in the Wild West.
Today options are much more widely understood, either because of the way investors learned about stock options during the Dot Com boom, or because of the role derivatives--including options--often play in modern financial scandals. But what is less understood is that trading options is as possible for the average trader as is trading stocks.
In fact, there are a number of good reasons why options may even be a better trading vehicle for you than stocks depending on your trading style and goals. Let's take a look at five reasons why options are the trade of choice for so many traders, and then look at two factors that hopefully will not be at the center of your decision to begin trading options.
Leverage
One of the main attractions of options trading is the leverage involved. For a small amount of capital compared to the average stock trader, an options trader can control a sizable amount of stock.
Leverage also allows traders to make a significant amount of money from a relatively minor movement in price. More than any other factor, leverage is the reason why traders and investors alike include options in their portfolios. What the trader likes in the power to make bigger bets with less money, the investor enjoys in the ability to completely hedge long-term stock positions at a low cost.
Trade Up, Down, and Sideways
Options give traders the opportunity to make leveraged bets on the direction of a stock. But by using any one of a number of options strategies ranging from the simple to the complex, traders can also look to gain from a stock that doesn't move at all. The ability to trade both direction (up versus down) and volatility (movement up or down versus little or no movement up or down) is an aspect of trading options that is often overlooked by the average options trader.
Hedge Your Stock Trades
The leverage of options makes them ideal tools for protecting or hedging a stock portfolio. For a relatively little amount of money, a trader can buy options against a longer-term long trade or investment and fully protect that long trade or investment from market risk. We have found that it is possible to fully hedge a long-only stock portfolio with only minimal reductions in overall returns compared to the unhedged, long-only portfolio.
Commissions Have Crashed
Commissions for options traders are not as low as they are for stock traders. But if the decline in commissions for stock traders has declined in recent years, commissions for options have plummeted.
The standardization of options decades ago paved the way for the growth in options trading volumes which continue to put downward pressure on commissions. The proliferation of discount online options brokers in recent years has also created the kind of competition among options brokers that should help keep option trading costs low.
Limit Risk
Traders who use options have the ability to completely control their exposure to risk. Buyers of put options, for example, risk only the amount of the premium paid up front. By contrast, a trader who sells a stock short can find him or herself deeply underwater if the position moves suddenly into the red. In a worst case scenario, a trader could be forced to cover at a level where the losses could be massive. There are a number of options strategies, from buying naked options to backspreads, which actually have a limited risk and virtually unlimited profit potential.
...And 2 Reasons Why You Shouldn't!
Quarter Calls and Dime Puts
One of the biggest temptations for new options traders is to load up on out-the-money (OTM) calls and puts because of their low dollar cost. New options traders, disproportionately undercapitalized, see the ability to buy out-the-money puts for $10 a piece on a stock they are convinced is headed to zero as a true gift from the trading gods.
But options are low-priced for a reason. And with expiration always getting closer, traders who buy way out-the-money options do not have the luxury of stock traders to wait around forever for the stock to move. $25 may be cheap for a put. But zero is even cheaper.
This is not to say that there is never a place for buying out-the-money options. But options traders--especially new ones--should be wary of the temptation to gobble up these cheap options like so many $1 lottery tickets at the convenience store. We all know where most of low priced options--like the vast majority of those lottery tickets--are most likely to end up.
Leverage
Yes, leverage. Leverage is both a reason to trade options as well as being a reason why some--particularly those with less self-control--should at a minimum stick with stocks.
Risk-seekers tend to be more attracted to options trading than the average trader--even though options ironically allow a greater control over risk than stock trading alone. The reason risk-seekers swarm to options trading is the same reason why many avoid it like the plague.
The same leverage that can deliver eye-popping returns, can break a trading account in half (or worse) just as quickly. The rewards--and dangers--of leverage can be particularly powerful when selling calls or puts, or when using any strategy that allows for unlimited risk. It is important for traders to remember that when it comes to leverage, a little can go more than a long way.
Trading is not for everyone and options trading is no different.
There are a number of factors involved in trading options that the average stock traders never loses a minute of sleep thinking about.
The role of leverage, expiration dates, and volatility are all among the factors that options traders learn to deal with and, eventually, exploit to their benefit. But if you are looking for ways to use leverage to enhance potential returns, or strategies to hedge your trading or investment stock portfolios, then options are as good a place to start as any other.
David Penn is Senior Editor at TradingMarkets.com.
