Derivative trading is becoming increasingly popular, not only in the investment field, but also in the general population. CFA candidates learn the basics of how options and futures can be used to hedge a portfolio. Options in particular are interesting as a trading instrument since they offer leverage to investors.
If you have limited knowledge or experience with options, I will explain here what is the “big deal” with options and why you should care about them!
In addition, we will answer some other common questions individual have with regards to options.
Who should care about options?
Options have been around for decades. However, since they are more complex than stocks they have never really been used by retail investors. Most people are scared since they are seen as riskier.
This is an erroneous belief and we believe every investor may benefit from gaining some knowledge and understanding of this asset classes.
This is true even if for individuals who do not plan to be a full time trader and trade options actively.
The majority of users of option contracts are either traders, hedgers, market-makers or finance professionals. However, options can be useful to:
- Anyone who has a traditional portfolio of stocks
- Anyone who has some capital and want to earn some money on the side
- Anyone who is able to follow a discipline approach and boost his returns
- Anyone who is risk averse and wants to be fully in control of how much risk they take on the market
- Anyone who have no idea of where stocks are going and are not good at “picking stocks”
- Anyone who do not have time or desire to conduct technical or fundamental analysis but still want to grow their assets in the market
What is the difference between a trader and an investor?
Although most of the participants in the options market are traders, it does not preclude investors from utilizing options.
In a nutshell a trader has a shorter time horizon than a trader. Traders in the option market typically have an investment horizon of less than 2 months. This is because unless you invest in long-term options (LEAPS), options have a monthly expiration date. Most option trades will occur on the front month expiration which is less than 1 month away.
On the other hand, investors have a time horizon measured in years and make much less frequent transactions. They build a portfolio and make adjustments periodically. This approach is not possible with options which usually require a more regular monitoring.
This does not mean option market participants have to stay in front of their trading screen 24/7. Some strategies allow investors to make money by making only a few transactions per month.
So what is the time commitment required to make money with options?
The secret of spending less time trading and more time doing … whatever you do is planning. Novice see options as risky because they usually improvise when implementing strategies and making transactions.
If you have the good approach, you can spend less time trading by applying the following process:
Why are options so cool?
Some investors and traders decide to focus only on stocks since this is what they are familiar with and other asset classes seem complicated, risky and reserved for experts.
Stocks are ok but options are much cooler. Here is why:
- Options offer a levered way to get equity exposure. Meaning you can achieve higher return with less capital.
- Options allow investors to express a more precise and sophisticated market opinion. Stocks have allow only to speculate on an upward or downward move. Options can profit from a wide variety of market view.
- You can make money with options even if you don’t know the stock market.
- You can define exactly how much risk you want to take on.
- Options investors can make money even if the stock stays flat.
- Even if the market crashes, option investors can still make money.
- You do not need much capital to make money with options.
- You can replicate a stock position (with less) money using options.
- Options can be used to generate income on stock holdings.
- There are over 20 different strategies that can be used with different risk/reward profiles.
How complicated is it to make money with options?
There are many different strategies, none of which should be applied without some basic understanding. The problem is that some individuals want to make money without learning the basics and migrate toward the simplest strategies. They usually lose money because even simple strategies require some understanding of option mechanisms.
Having said that, there is no complicated math or formulas required to use options effectively. One just need to understand some essential relationship and the various factors that affects option prices.
Option prices do not behave like stock prices. There are more factors involved which is why some say options are complex. However, once you learn these factors and how they interact together, you will be ready to use any strategy to make money in the market.
What is required to be a good trader?
We think there are three things required to be a good trader. In this sense, “good trader” means making money most of the time and minimizing losses.
Losses are part of the game and even the best traders and investors will incur them sometimes, regardless of how well prepared they are and how well they planned their trade.
As Mike Tyson once said:
“Everyone has a plan, until they get punched in the face”
The mastery of the three attributes will determine how well you react to losses. A good trader is defined by his losing trades rather than his winners.
3) Discipline and Emotional Control
Our partners at Options Trading Ninja show you how to acquire these skills in their new Ultimate Options Trading Guide. They also offer a toolkit that will allow you to start making profits in the options market.
For Financial Analyst Warrior readers get a 20% discount on the Trading guide or Trading packages. Just enter the code “FAW20” upon purchase.
Let us know what you think and if you have any experience with options trading!
Checkout our partner’s website at optionstrading.ninja!