Options Trading has a reputation for being extremely risky,
but this reputation is in large part undeserved. True, option trades ARE
extremely risky - even dangerous if you have no idea what you are
doing. However, that is true of all forms of offline or online
trading, and trading in options is no exception.
While options trading has this reputation among laymen, it is often
considered to be a form of risk limitation with professional
traders. After all, in what other form of investment can you
guarantee the maximum loss you can suffer right at the point where
you enter the trade?
Options are contracts that give the purchaser the right to buy or
sell an underlying security, such as a stock, a bond or a commodity,
at a fixed price and for a fixed time period only. You can find
options on underlying securities such as stocks, mutual funds,
bonds, commodities, and more.
Option trading gives you the chance to exploit a whole range of
market opportunities that are unavailable with conventional online
stock or forex trading. For example, one class of option trade
allows you as the buyer to make money if you expect the market to
move strongly in one direction or the other, but you are not sure in
which. If you are the seller of position, by contrast, you are
betting that the market either goes nowhere directionally and/or the
volatility declines.
Trading in options can actually lower your risk. For
example, whenever you buy an underlying stock, there is always the
extremely small, but non-zero, risk that the company can go bust and
the stock price can first be suspended and then go to zero. That
means that your potential loss is the point difference between the
price you entered the stock trade and zero, multiplied by the number
of shares you own! If you had done the corresponding option trade by
contrast, i.e. buying call options on the stock, your loss would be
simply the price you paid for the options.
Where options ARE very risky is where untrained traders go "naked
short", as it is called. In one common example, they sell put
options on a stock index future and collect the option premium as
payment. This gives the buyer the right to sell the stock index
future back to the put option seller at a fixed price, called the
strike price. This is fine as long as the underlying index continues
to rally and the strike price is basically never reached. However,
in one famous example, one hapless option punter, who had been
happily selling put options on the FTSE index futures for
years and collecting the cash, got badly caught when the entire
stock market crashed in 1987, and the option buyers exercised their
right to sell their positions at prices MUCH higher than the current
market!
However, such foolishness apart, option trading can be an
extremely profitable way to trade in stocks, forex, bonds,
currencies or whatever. When used properly, they can actually
limit your risk drastically. Option trading can allow you to create
positions and exploit market opportunities not otherwise available.
Best of all, if you combine options with the underlying instrument,
you get to create a whole range of interesting risk profiles.
The key to success in option trading is, as with anything
else in life, to study the subject hard before trying to trade and,
if possible, begin by paper trading the market. Once you are
satisfied that you know what you are doing and have a valid option
trading methodology, then you can begin risking real money. Even
then, you only trade very small to start with and with money that
you can afford to lose. Once you know what you are doing, and your
account size show some nice profits, then you can afford to trade
progressively larger size for progressively larger profit.
