Options Trading

Even if you don't know what options are, you've probably heard of them. Politicians and newscasters alike blamed "complex derivatives" in part for the financial crisis of 2008, and options are a form of derivatives. Indeed they are complex, and if you're considering options trading as part of your investment strategy you should think more than twice before you act. To make money trading options you'll have to predict future market movements with a high degree of accuracy, which is all but impossible over the long run.

The common use of the word option describes options well. An option gives you the right to buy or sell an asset at a predetermined price on or before a predetermined date. There are two primary uses of options trading:

  • To make money through speculation by timing the market
  • As a form of insurance against future losses

Option Types

There are two different types of options, calls and puts. A call gives the holder of the option the choice to buy an asset on or before the expiration date for the predetermined price, and a put gives the holder the choice to sell an asset on or before the expiration date for the predetermined price. In addition to being a holder of an option you can also be a seller or writer. Holders are never under any obligation to buy or sell their options. They simply have the choice to do so. But call and put writers are obligated to buy or sell if the option holder exercises that option.

The price of an option is called the premium, and is based on the current stock price, the strike price or predetermined buy/sell price, and the amount of time before the expiration of the option. If the value of an asset an existing option is based on is higher than the strike price of the option, and if that option is a call, then the option has a positive intrinsic value. On the other hand, if the value of an asset an existing option is based on is lower than the strike price of the option, and if that option is a put, then the option has a positive intrinsic value.

Risk vs. Reward

It sounds complex because it is. To make money trading options you'll not only have to be correct about the up or down movement of an asset, but also to a greater degree than with traditional speculative investing. Because buying an option costs money, the value of the asset will have to go up above and beyond the money you've spent on the option in order to profit. And if it doesn't, you'll lose the premium with nothing whatsoever to show for it. Your option will simply expire. If you consider how volatile the markets are, how quickly they can change, and how difficult they are to correctly predict on a consistent basis, the prospect of making money through options trading is high risk at best.

You may be wondering why anyone would buy options with such increased risk. The reason they do is the prospect of what some consider a disproportionately high reward. In regular speculative investing lets say you purchase 10 shares of XYZ Company for $1000. If they go up to $1100 over some period, then you make $1000 in profits. Because the cost of an option to buy shares is far lower than the actual cost of buying the shares, you can purchase an option to buy 1000 shares for the same as the cost of 10 shares, for example. So if you purchase 10 options (at 100 shares per option) of XYZ Company with a strike price of $1,050 and the stock goes up to $1,100, you can then make $50,000 by exercising those options, minus the cost to purchase the options in the first place. These numbers are entirely fictitious of course, and the potentially disproportionate gains have to be weighed against the likelihood of both losses and decreased profit due to the purchase of the options when assets do not appreciate far enough above the strike price.

Another considerably less risky use of options is as a long term insurance or hedge against your investments. You may for example buy options to sell your assets at predetermined prices lower than they're currently worth. So if you're assets are valued at $100,000 and you purchase options to sell them for $90,000, if they drop to $50,000 you'll have limited your losses to $10,000 plus the cost of the options. This strategy can be useful for large investment companies, but is less likely to be useful for the average investor with a balanced portfolio.

A safer option for long term financial success is smart investing through diversification. While you won't have the same chances for quick, big wins, you'll also be less likely to suffer big losses. Over time, a widely diversified portfolio is likely to perform better for you.