Magazine article Modern Trader

Understanding Options: Traders Are Faced with a Number of Choices, from How to Analyze Markets to How to Implement That Analysis. One of the Most Important Decisions Involves the Trading Vehicle Itself. Many New Traders Are Increasingly Turning to Options

Magazine article Modern Trader

Understanding Options: Traders Are Faced with a Number of Choices, from How to Analyze Markets to How to Implement That Analysis. One of the Most Important Decisions Involves the Trading Vehicle Itself. Many New Traders Are Increasingly Turning to Options

Article excerpt

Options are vehicles to take you where you want to go. As a new trader, do not look to them to tell you where the market is going. You are the driver. Options are simply a tool you can use to exploit your analysis of the market in unique ways.

Most would-be option traders get started with futures, and it can help to view options relative to futures. There are many trade-offs between futures and options. When you understand how options work and know the right strategy for the given time frame, they can help you avoid some of the pitfalls of futures trading. Some of those include implementing a trade with an improper risk/reward outlook, getting stopped out, emotional decisions, poor money management and letting a bad trade become worse.

What are options? Call options are contracts that give the buyer the right, but not the obligation, to buy the underlying market at a stated price (the "strike price") before or on some date in the future (the "expiration date"). Put options are contracts that give the buyer the right, but not the obligation, to sell the underlying market at a stated price before or on some date in the future. The option seller takes the opposite side of the position. That is, he assumes the obligation to sell or buy the underlying if the strike price is met. The option buyer pays the option seller the option premium for assuming this liability.

With active and liquid markets in hundreds of options available today, it is possible for individual investors to buy and sell these contracts in seconds--just as easy and fast as you can with stocks or futures.

However, despite their benefits, unless you know how to use options properly, they will not help you. Indeed, an improperly applied option-based strategy can create greater losses than a futures-based position. With options, you can be "right" the market and still lose money if your position is constructed wrong. However a properly constructed position can allow you to profit even when you are "wrong" the market. The proper strategy and the discipline to apply it are a big part of being successful.

WHO SHOULD USE OPTIONS?

Small or large accounts can benefit from option trading, but an account under $25,000 has more reason to use them. Many markets can move $4,000 in a week per one futures contract, which would be too big a percentage of risk for a small account. Options give an advantage to controlling risk that futures alone do not have.

Imagine being caught in a limit move against you with a futures contract. Now you are in jeopardy of losing more than you thought because the market has opened well past your stop. You are stuck with the position and can't get out. This cannot happen when you buy an option. When you buy an option, your loss is limited to what you already paid for the option itself.

In a nutshell, options lose less as the underlying futures price moves against the position, and options gain at a higher rate of return when the underlying moves with the position.

Options allow you to use them exactly as you want to fit your thoughts, ideas, and time frame. Using a standard selection of option-trading strategies, you can make money if the market goes nowhere, explodes up or down, marches in one direction, and even if you are partially wrong on your market analysis. Futures do not offer that benefit. What futures offer is, in general terms, a much more liquid market (except for the highly traded options) and the satisfaction that some receive for knowing whether they are right or wrong starting from the next tick after entry.

THE ROLE OF ANALYSIS

While options strategies are enormously flexible, market analysis still plays an important role. To obtain the best results with his options positions, the option trader must be a market strategist.

Being long option premium strategies limits the risk, while futures present the hazard of uncontrollable, unlimited loss. …

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