Why Trade Options?

Why trade options? If you have the skill (or luck) to know when a stock is going to move higher or lower, why not just buy or short the shares? The same can be said for commodities – why trade options when you can trade futures contracts?

Too many people look at options as tools for speculation. Sure, options provide leverage, giving you the possibility of turning a few hundred dollars into several thousand dollars. And yes, that possibility is attractive. But do you play the lottery – just because the prize is huge? Everyone knows the lottery is a bad bet and that the chances of winning are terrible.

But options cost more than lottery tickets and the payoff is smaller. The probability of success is small because so much must go your way when you buy options: price change, timing of that change, size of the change. It’s a tough road.

Options were not designed as tools for speculation, and if you want to get the most out of options, consider using them as they were designed – as risk-reducing investment tools. It’s not sexy to ‘prevent losses.’ It’s much more fun to triple your money in two weeks. But tripling your money doesn’t happen often enough to make seeking that goal worthwhile. And, if you successfully protect your assets and avoid getting hurt when the market heads south – as it does in any bear market – then your long-term success may not be guaranteed, but your chances of having that success are much greater than investors who fail to manage risk.

Options are powerful investment tools. Option positions can be readily analyzed to measure specific risks (the option Greeks) associated with your investments. Then you can adopt option strategies to reduce or eliminate any or all of those risks. Stock investors can recue risk by owning a smaller position. Option traders can modify risk associated with time decay (theta), exposure to a market move (delta), change in implied volatility (vega) or interest rates (rho), etc.

Less risk; portfolio protection with profit opportunity; isn’t this an excellent combination of attributes for an investment portfolio? Does the idea of using options to protect the value of your holdings sound good? The collar strategy than do just that.

Perhaps too many investors are unaware that options were invented to reduce risk. The negative side is that protecting profits at a reasonable cost translates into having only limited profit potential. Does that stand in your way? Conservative option strategies are not for everyone, but every investor ought to be aware of how options can be used to insure the value of a portfolio.

Mark Wolfinger, @MarkWolfinger, is a 20 year CBOE options veteran and is the author of the book, The Rookie’s Guide to Options.

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