Options As Power Tools for Every Investor

by: Kevin Cook

I took my first class on options from Sheldon Natenberg, author of the trader’s bible Option Volatility and Pricing and one of the top instructors in Chicago. One of his favorite analogies is stuck in my mind, and I try to apply its wisdom every day in trading. To paraphrase:

Options are power tools, and that power has risks as well as rewards. Just as we can use a saw to either cut a piece of wood precisely, or cut off our hand, we can use options to control assets for profit, or create more risk for ourselves.


I bring this up because I’ve lately found myself explaining more complex option strategies, such as calendars and diagonals. I think options trading is fascinating and so I always enjoy working with a variety of its tools in different market environments. But, I also want to make sure every trader that listens to me understands all the risks of any strategy I’m talking about.

What makes options power tools? A combination of four things:
• High Leverage
• High Versatility
• Lower Cost (relative to their underlying stocks)
• Lower Risk (relative to… Oh, just see below)

This last point needs further commentary. Options give you “lower risk” relative to conventional long or short positions in stock, IF you are in a limited risk strategy, say when you buy a call or buy a put spread.

Even then, you must weigh that defined risk against what you are trying to accomplish with the stock and see if you have achieved the balance of risk and potential reward (or hedging) you’re after. Paying too much for an option or a spread with a low probability of success may create more risk than if you had done nothing—even if you were right about the direction and magnitude of the stock move.

The Probabilities of Risk and Fun

What makes options endlessly fascinating? Endless combinations. And the three-dimensional complexity that comes from managing stock risk across the spaces of time, price, and volatility.

Some people love casino games, like poker or craps, because betting on random outcomes is fun. And it’s even more fun when you think you can gage probability accurately in card games, where a gaming edge is actually possible, as opposed to roulette where the probabilities are stacked against you from the start.

Options markets offer even more opportunities and variety to search for trading edges. There are nearly 2.6 million five-card poker hands while the combinations of stock option strategies easily puts the possibilities in the tens of millions.

Just thinking conservatively, 2,000 stocks x 10 strikes (figure five each for puts and calls) x 4 months = 80,000 options to chose from. Multiply that by 40 (10 strikes x 4 months) and you get the idea of the combinatory possibilities as we just stuck our head above three million without even trying.

Something for everybody, in all risk and time frames. Plus, since options trading thrives on the “stock stories” underneath them, they deliver a whole lot more interesting and variable outcomes than 52 cards ever could.

And before you enter a single one of these million-plus trade ideas, you get to evaluate them for their risk and reward characteristics and potential. How? By simulating the position in a P&L Calculator or Risk Viewer like the ones at OptionsHouse.com. Even if you’re just learning a strategy, I can think of no better way to understand its risk profile than to see it visually in these calculators and tools.

So, if you haven’t made options part of your investment tool box, now’s the time. The tools available today to the self-directed investor to learn and trade and manage risk are so powerful and easy to use, option pros only dreamed about them 10 years ago. If you don’t have an options trading account, talk to your broker or investment advisor and see if you’re ready.

Then check out the tools we use every day at OptionsHouse to learn and teach option strategies. Even if you’re not ready to trade, it costs nothing to open a free virtual account and learn how to use the tools that help you make use of the ultimate financial power tools—options.

Source:
          Options News Network

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