Options Trading is A More Complex Form of Speculation
Options trading is also more complex in several ways than other forms of trading. Generally, all one does when one wants to speculate on a security is to look to predict its movement over a period of time, and then either buy it if one believes the price will go up over a certain time frame, or sell it (short it) if one feels that the price will decline.
Although a lot of people think of investing as owning something, going long a security as it is known, and there is certainly a bias towards long positions with the stock market in particular, there is no particular reason why one has to just go long, or buy, as one can speculate on price movements in either direction.
Options do provide the means to do this, to buy calls if one expects the price to go up, or to buy puts if the feeling is that it will go down. One can also sell calls and puts where they take the other side of the trade, and selling options is another means of speculating, only with selling or writing options you’re betting that the price will not go down enough or go up enough.
The ability to both buy and write options contracts already makes options trading more complicated than with other securities, but one can just simplify things and just buy them if one wishes, so this in itself does not need to complicate things.
The real reason why options trading is more complicated isn’t this, it’s that there are a number of other variables in the trade. You need to choose both the expiration date of the contract and the strike price, the price that you are betting that the option will surpass in order to yield a profit.
If an option does not surpass its strike price, the option contract cannot be exercised, and will expire worthless.
This leaves the trader with the constant decision of whether to hold the option longer, or to sell it in the market for whatever it will bring. Options are publicly traded and their value changes throughout the life of the contract, as other securities do.
Time and Volatility With Options Contracts
Adding to this complexity is the decision of how long to maintain your position in the option contract, and this is more complicated than just figuring out where the price of the asset is headed and trading it according to your expectations.
Options also involve the element of time, where options experience time decay. Options represent the potential value of the price change of an asset, not the price change itself.
So, all other things being equal, an options contract will be worth less as time passes, due to a lesser amount of time existing for the price to change. This must be accounted for when trading options.
Implied volatility is another element of options trading, and is priced into the premium, and can change while in the trade. Implied volatility is the other side of options, the potential for movement, along with the element of time, how much time is involved in allowing this volatility to play out.
All of this becomes priced into the cost of the options though, quite efficiently, as when this gets out of line to a meaningful degree, people will step in to buy or sell them which results in the price of the options being corrected.
This is the real beauty of publicly traded securities, as if there are imbalances in a market, such as an option being underpriced or overpriced, then arbitrageurs will step in to keep things in line. These things do happen, like they can in other markets, but if there’s money to be made from an imbalance, someone will step in and look to make it.
Given this, it is not necessary to have a deep or even a good understanding of options pricing in order to trade them successfully, because the market polices itself to a good enough extent, providing that you are trading options that have a good amount of liquidity.
All options traders should at least have a good idea of what they are buying though, which is essentially the potential for a certain profit, which is shaped not only by the price and the trend of the underlying stock or other security, but also by time and potential for movement.
The Particular Challenges of Options Trading for Profit
In a sense, all financial trading involves a transfer or risk from the buyer to the seller, as well as a transfer of opportunity. If you buy a stock for instance, the risk of the position losing value is transferred to you from the previous owner, as well as the transferring of the opportunity for it to make money.
This is how options work as well, other than the risks and opportunities being magnified. The risks are magnified for the seller, more so than with normal securities transactions, and the opportunities are magnified for the buyer of the option.
The price paid for this transfer of risk is the premium, so the premium will be priced according to what the market sees this risk as being at the time of the trade. Options, like other derivatives, are a zero sum game, where net of trading costs, every dollar made by one options trader will be lost by another.
Financial markets already price in all the available information at any given time, so this makes it difficult to profit from options if you’re just looking to trade what is known about the securities themselves.
In order to beat the options market, you’re going to need to be able to predict price movements themselves better than the market does, although this is something you are going to need to successfully trade any derivative.
What makes options trading more challenging is that you’re going to have to beat the average of some players who are quite knowledgeable and sophisticated, making options perhaps not the best choice for budding traders who don’t know a lot about what they are doing yet.
While one can simply look to buy calls and puts and not delve into the more complex side of options trading, keeping things as simple as possible, the changing dynamics of options pricing makes day to day decision making more difficult than other types of financial speculation, and this is where the real challenge lies.
While buying options only involves a maximum risk of the premium paid for the option, the option’s price in other words, one can easily lose a substantial portion or even their entire investment in the options contract if one is not careful, so while this is considerably less risky than the risk that the options seller may take on, it’s still pretty substantial.
Strategic Risk with Options
Provided one is practicing proper account management though, and not taking larger positions with options trades than one can handle, the risk of an option becoming worthless should not be all that much of a concern.
The idea here needs to be to place oneself in a position where they can withstand a number of these losses without much hardship or concern. This is not always the case with options traders though although it’s a lesson that will be learned fairly quickly as one gets into enough trouble.
The ultimate risk with any trading scheme is strategic risk though, the risk that the strategy that is being used not having a positive expected return overall.
The goal of all trading is to leverage one’s positive expectation, and options trading is highly leveraged, so if one can withstand the normal drawdowns and has a positive expectation then this will tend to lead to success.
If one instead has a negative expectation, if the trading strategies used lose money over time rather than make money, then it’s just a matter of time before one goes broke. Given the additional leverage and risk of options trading, having a sound strategy becomes even more important than it usually is.
The goal with trading anything always needs to be to work out a winning strategy first, and then look to leverage this advantage. Trading options can accelerate this advantage, or it can accelerate this disadvantage, making it even more important with options to know what you are doing and be good at this.
There are many traders that successfully speculate on options by buying them, in addition to those who speculate on the selling side and manage their risk appropriately. Doing so requires some real skills, and is perhaps as far away from the buy and hold strategy that most investors in the market take, but the rewards in options are very significant if and when you get this right.
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.
