The objective of every trader is to make money, but with an acceptable amount of risk.
We find that one of the major issues for new options traders is because they have no idea how to use options to achieve their financial goals.
Buy low and sell high is certainly one way to achieve your goals but that is not good enough for traders new to options. In fact, many time option prices do not alway behave as we expect.
I will give you a good example based on experienced stock traders.
Most traders have heard the term selling short, but what it means is that you are hoping to profit when the price of the stock declines.
Too many new options traders do not take into account that they can sell options rather than buying them.
Since options are a very unique investment tool, there are many techniques a trader has in their toolbox other than simply buying and selling individual options.
Options are unique in the investment world.
This is going to be a quick breakdown on the mathematical tool called The Greeks.
It is used by traders to measure risk.
If you have a hard time grasping how important it is, think about this:
If you can measure risk (i.e,, maximum gain or loss) for a given position, then you can . Translation: Traders can avoid nasty surprises by knowing how much money can be lost when the worst-case scenario occurs.
Similarly, traders must know the potential reward for any position in order to determine whether seeking that potential reward is worth the risk required.
From TheBalance, a few factors that options traders use to gauge risk/reward potential:
- Holding a position for a specific period of time. Unlike stock, all options lose value as time passes. The Greek letter “Theta” is used to describe how the passage of one day affects the value of an option.
- Delta measures how a price change — either higher or lower — for underlying stock or index affects the price of an option.
- Continued price change. As a stock continues to move in one direction, the rate at which profits or losses accumulate changes. That is another way of saying that the option Delta is not constant, but changes. The Greek, Gamma describes the rate at which Delta changes.This is very different for stock (no matter the stock price, the value of one share of stock always changes by $1 when the stock price changes by $1) and the concept is something with which a new options trader must be comfortable.
- A changing volatility environment. When trading stock, a more volatile market translates into larger daily price changes for stocks. In the options world, changing volatility plays a large role in the pricing of the options. Vega measure how much the price of an option changes when estimated volatility changes.
Spreads for Hedges
Most of the time options are used in combination with other options, like buying one and selling another.
To the untrained eye, it might be confusing, but the idea is actually quite simple.
When you have a gut feeling about the underlying asset, such as:
- Neutral (expecting a range-bound market)
- Becoming much more, or much less, volatile
Options can help you can construct positions that earn money if your expectations come true.
The total number of combinations is pretty enormous.
You can search and find information on a variety of strategies that use spreads.
Our LOOT! service comes with hours of education on how to effectively use them,
Spreads have limited risk and limited rewards.
However, in exchange for accepting limited profits, spread trading comes with its own rewards, such as an enhanced probability of earning money.
The somewhat conservative investor has a big advantage when able to own positions that come with a decent potential profit — and a high probability of earning that profit. Stock traders have nothing similar to option spreads.
Remember, options trading is not stock trading.
Educated option traders know that is a good thing because option strategies can be designed to profit from a wide variety of stock market outcomes.
And that can be accomplished with limited risk.