Overusing Options to Speculate

When we take a direct position in a trade, whether that be with an asset or a derivative of it, the outcome of the trade will proceed in an orderly fashion, according to the price movements of what we are trading.

If we go long and the price increases, we have gained the exact amount of the movement less trading costs. When the price moves against us, we lose the exact amount of the movement plus trading costs.

Overusing Options to SpeculateWhen we use trading to speculate, we are speculating on where the price of something may move over a given period of time, the time frame of our trade. While this is not an easy process by any means, and does require a fair bit of skill to be consistently successful in doing so, we at least are looking to define our risk and set our objectives in a pretty simple fashion, according to where we expect the price to move to, and the probabilities of this happening.

Options trading involves all this, plus the additional considerations of magnitude and time. When we buy an option, a certain movement will already be priced into it, and this will also depend on how much time we have for the trade to play out.

These additional considerations, making up the option premium, is what makes options trading considerably more complex than non options trading, and does require at least a good understanding of how this all affects the desirability of trading options in a given situation versus trading the underlying asset directly.

As a rule of thumb, and a very good one often times, simpler is better when it comes to trading, and options are anything but simple. For many traders, the simplest is the best, where one may just trade one asset and trade it with simple and clear cut trading rules and by doing so can reduce the number and magnitude of mistakes.

The Challenges of Speculating with Options

Those who possess greater skills may entertain more complex strategies where the potential for trading mistakes are greater but the ability to avoid these mistakes is also greater. In doing so, there may be more potential for success, although it is not necessary to take on trading complexities to enjoy great success in trading if one does not wish to.

Options are clearly a complex way to trade, more so than any other form of trading, and even though this complexity can be managed with the right skill, understanding, and experience, all of this is required in sufficient amounts to make sense of trading this way.

With options, we need to be more certain about both the probability and the magnitude of our expected changes in the price of something, where with normal trades we only have to be sure enough that it will move at all our way.

In a real sense, options move against us over time even without the price moving, and other factors that may affect the potential for the price to move also exert their forces upon it, such as the market moving or expectations of market moves, as well as pretty much any form of fundamental influence.

Instead of just having to look at the chart and look to make predictions, options introduce a number of other variables, and while the potential for profit may be greater in some situations, the risk tends to be greater as well.

We now have to deal with a much more dynamic situation, where we not only have to be right, we have to be right in a big enough way, and we can be right and still lose on the trade, and lose the entire amount we put up as well.

If we are right enough though, we can profit more than otherwise, and the trick is to be able to tell the difference well enough between those situations which actually do offer enough additional profit potential to justify the additional risks involved, and also be able to comfortably bear those additional risks as they come to pass.

Many traders get into trading not near prepared enough, and this leads to most traders failing to succeed. When it comes to trading options, with the higher requirements of skill and understanding involved, the risk of this happening is even greater, and even more care must be exercised to make sure that one is indeed ready for this more complex form of speculation.

Even if a trader has a correct view of the movement of an asset, with options, this is not enough, even if one sticks to in the money options where one isn’t immediately in a position to lose unless the price moves enough. If, during the trade, the price doesn’t move enough in one’s favor, one can lose as well, and options trading is all about speculating on amplitude, not just direction.

Speculating on amplitude is a whole different exercise, and one that is at best considerably more difficult to be consistently successful with. A trader may even have a strong history of being successful in other trading and still will need to prepare himself or herself with the distinct nature of options speculation in order to be prepared enough to risk any kind of serious money.

While many of the skills do transfer over well, there are certainly some unique challenges with speculating on options and having a good grasp of this isn’t optional.

The problem is, like we see in all forms of trading, the majority of entrants simply do not have a good grasp of what they are doing, and end up paying the price for this. The hope is that one may learn as one goes, and achieve enough mastery before they give up or go broke.

Given that options speculation requires a higher level of mastery, it therefore becomes less likely that traders who enter this form of trading unprepared will get to where they need to be in time, and this means that it’s even more important to develop one’s skills more prior to speculating with any degree of serious money.

Options Should Never Be Used Just for Leverage

Should one simply wish to leverage their positions, while options do provide a way to do this, this in itself should never cause us to want to trade options instead of trading something else.

The added leverage of options is what draws in so many people to options speculation though, where they see the greater potential for returns on a percentage basis that options clearly do promise, and that is what excites them and makes them want to trade them.

In many cases, traders will choose options simply because they don’t have the means to trade the underlying asset. They don’t realize that they are just as underfunded when they trade options, and if you can’t afford the asset there is no way you should ever be considering putting all your money in options to speculate on it.

This is a great way to lose all of your trading funds, and even though we may only have a small amount of money to trade, and losing it all may not be all that big of a deal, it is simply foolish to go all in with a form of betting that simply cannot accommodate the risks and it’s just a matter of time before things become completely unravelled.

It is paramount that we have enough equity to withstand whatever drawdowns we may expect from a trading strategy and withstand them quite comfortably. Not taking a strategy that ensures one is comfortable with the risks involved is a mistake that even long-term investors tend to make, where bear markets may cause them a great deal of stress and even cause them to make big mistakes.

This is not just a matter of having enough money to trade, we also need to make sure our strategy itself is in line with our comfort level, and one must be quite well funded to handle the risks of options speculation because the nature of this trading is going to involve significant risks generally.

The lure of larger profits is pretty nice, but we also need to account for the specter of major drawdowns, and if the drawdowns we are exposed to are indeed major, then speculating on options may not be appropriate for us right now.

What it Takes To Be Successful Speculating with Options

While trading success does require an edge, it also requires that we be able to manage the risks of our edges, and we require both in all cases to be present to be successful over time. Most people who speculate on options have neither.

If you don’t know what you are doing, leverage is the last thing you want, especially the high amount of leverage that options speculation offers. What you end up doing in this case is leveraging your market disadvantage, and this will mean that you will experience much greater magnitudes of risk and losses, and go broke much more quickly.

Leverage can be very appropriate if one is leveraging an advantage though, and can manage properly the drawdowns that may occur, and this is what we need to have in place at a minimum to become a profitable options speculator.

If we are just after the leverage part of this though, there are other ways to get this much or more leverage, trading futures for instance or contracts for difference. Whenever we are looking to speculate on options, no matter how great our trading advantage may be, we always want to consider the pros and cons of options speculation versus these other highly leveraged forms of speculating.

There are instances where options speculating may be the chosen path, and in some situations options may be the better way to go, although we do need to consider all factors and not just decide based upon our liking the idea of options, having experience trading them, or just simply preferring the higher level of excitement that they can provide us.

What we never want to do is engage in options speculation where we are not prepared for it, aren’t skilled enough, don’t understand them enough, don’t have the capital to trade them comfortably, aren’t prepared to take on the risk, or when trading the asset directly would make more sense.

When we do not have everything in place to be in a position to succeed at trading, we are unlikely to succeed. This is perhaps especially the case with options speculation. If we do have everything in place though, options speculation can be plenty lucrative.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.