What is Option Trading?

Option trading often seems to have an air of mystery and secrecy surrounding it, but in fact it is a simple tool used by both large investment firms and by individual investors. Every few years, a story emerges in the media about a lowly bank official who has lost billions for his firm through a series of bad derivatives trades, and this kind of press exposure has tended to give options trading a bad name. While there certainly are risks associated with options trading, most traders use options as a means of alleviating risk. So, what is option trading, actually?

Insurance against Stock Market Crashes

To explain using an example, a major investment firm may have purchased a large number of shares in a particular company for its clients. If a market dip occurs, the prices of this company's shares are also likely to decrease, even if the company is fundamentally sound. Any good investor will set a stop loss trade, in an attempt to sell the shares before they go too low. The disadvantage of this strategy is that frequently, nobody wants to buy the stock, and so the investor remains unprotected. However, if the investment firm buys a 'put' contract on the shares that it owns, it provides a rock solid guarantee that they will be able to sell the shares at a certain fixed price, even if those shares are trading much lower at the time. So, in effect, the firm is buying a form of short term insurance to ensure that its investment is protected to a certain level. In this way, it protects its clients from heavy losses, and simultaneously protects its reputation.

Securing Future Profit Potential

On the other side, say a major company such as Apple anticipates releasing a new product in the next few months (perhaps a new iPhone). Because Apple is notoriously secretive about new products and release dates, the anticipation can create a bit of a feeding frenzy in the market, and share prices can reach unreasonable levels. In this case, an investment firm may want to buy up large blocks of stock for its clients, but for the best possible price. So, before the frenzy starts, the company may purchase the right to buy the stock in the future at a set price (this is called a 'Call Option' contract). This then is a guaranteed price that it can pass on to their clients. Naturally, if the stock has increased in price over that period, the clients will benefit from the foresight of the investment company, and will make an immediate profit. If, on the other hand, the price is lower, the firm will simply allow the option to expire, and buy the stock at the lower price. Either way, it ends up with the best possible trades for its customers, and if course its reputation is protected.

Individual investors can use options in exactly the same way as major investment firms, although obviously in much smaller quantities. In some ways, it is not too different from taking out a mortgage to buy a home. You use a small amount of your own money, combined with the bank's money (which you don't actually ever receive or touch) to control the ownership of a property much more expensive than you can afford. If the housing market grows, you get the full benefit of the growth, even though your own financial commitment is relatively small. This is the principle of leverage. You can use options to control ownership of large blocks of stock that you don't ever actually need to own, and you can also protect stock you already own from large market fluctuations.

Options give you flexibility!

The real beauty of options trading is the flexibility. Instead of buying 'insurance' for your stock in case of market fluctuations, why not sell options, and so become a form of insurance salesman? You can even do this with combinations of different options contracts to ensure that you are protected as well. These types of strategies (with crazy names such as 'credit spreads', 'iron condors' and 'butterfly spreads') are simply variations on a theme, designed to gain value while minimising risk. Each strategy has its own characteristics, and its own risk profile, but it is worth learning about them and using them. We are often advised by investing gurus to protect our capital by diversifying our investments, but what about diversifying our investing strategies as well?

What is Option Trading?

What is option trading? It is a collection of strategies that any investor can use to bring growth and diversity to his portfolio without increasing risk. We use these types of strategies all the time in our private lives (I gave the examples of mortgages and insurance) - why not use them in investing?

Not sure where to get started? Visit these pages for a thorough grounding, and then investigate some of the different strategies:

TOP TIP: If you are completely new to options trading, the best way to learn is to practise, practise, practise.... The Iron Condor 101 Trading Simulator is a fantastic way to do this. You make repeated trades using historical data, and learn how to manage, exit and adjust every trade until you get it right every time. The experience you gain will be equally valuable for selling both iron condors and credit spreads. Give it a try, with a full monay back guarantee.

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  • What is Option Trading? Hig risk trading or risk aversion? Can ordinary investors get involved, or is this only for the 'big boys'? I hope to answer these questions on this page.

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