Is trading options a good idea
However, the fact is that there isn't really a huge amount of scope for using advanced strategies to increase your level of profits. Even if you are actively trading stocks, there are certain limitations involved. In very basic terms, you can either buy stocks that you think will go up in value or short sell stocks that you think will go down in value. There's certainly a bigger range of strategies that can be used when taking the buy and hold approach, and a number of different methods that can be used to determine what trades to make and when.
However, the flexibility and versatility in options trading means that you will find many, many more opportunities for making profits in any prevailing market condition. For one thing, options can be bought and sold based on a wide variety of underlying assets. As well as speculating on the price movements of stocks, you can also speculate on price movements of indices, commodities, and foreign currencies.
This fact alone means there are a huge number of identifiable opportunities for potentially profitable trades. For example, you may have a particular skill for predicting changes in the forex foreign exchange market as well as a solid fundamental knowledge of a specific industry. You could use your skill in the forex market to trade options based on foreign currencies and also use your industry knowledge to trade options based on relevant stocks.
The potential for finding suitable trades is almost limitless. The range of actual trading strategies that can be used is also huge. In particular, spreads offer true flexibility in the way you trade. Whether you are looking to limit the risk of taking a position, reduce the upfront cost of taking that position, or attempt to profit from price movements in more than one direction, it's spreads that make for true versatility.
They can also be used for hedging existing positions, which can be very useful in uncertain times. It's also possible to use options spreads to profit from a stagnant market, something that is very difficult when trading stocks. It's fairly easy to see why trading options is becoming increasingly popular among many investors.
It's no longer just the professionals that are involved, because more and more casual investors and home traders are taking advantage of the benefits on offer.
It isn't without its disadvantages though. It's fair to say that mastering options trading is no simple task, and there is definitely a lot to learn. As you can see, all 3 sources of information — public news, insider information, and guessing — have serious drawbacks; as a result, you are unlikely to make effective trades solely based on information.
As a corollary to the EMH , it means stock prices are always correct and fair, every day, every minute. If you buy something because you expect its price to go up in the future, it would be a mistake to attribute your expectation to intuition or common sense — your expectation is based on mere belief , because anything that is a fact is already reflected in the security price.
These forecasts are a mixture of public news and mere guessing, which is not information that you can profit from. Irrational behaviors and cognitive biases cost you real money. These flaws in human reasoning are studied academically in fields like economics, game theory, and psychology, but when you make financial decisions according to a false interpretation of reality, you will end up with money-losing consequences with high probability. People acquire essentially all of these biases by nature; it takes conscious effort to recognize them and mentally train against them.
These irrational behaviors take a bit of reading and serious thinking to understand, but truly recognizing them in real life is much harder than it sounds.
When learning about these behaviors, the examples are purposely contrived and quite clear-cut. Institutional investors are big, powerful players in the financial markets. For example, these are organizations that control a mutual fund, pension fund, hedge fund, university endowment fund, etc. When institutional investors make investment decisions, they do it with expertise and influence.
They employ professionals who are trained in finance and have experience working in the field; they employ people whose job is to monitor prices, analyze trends, and find non-obvious facts about the world. Because of their large size, they can negotiate discounts and special deals with sellers; moreover, they can buy smaller companies outright and revamp their management for better profitability. You, as an individual investor, have none of these advantages. In addition to humans, computer programs also participate in trading.
Modern computers are spectacularly cheap and powerful, and a single computer can easily do a billion calculations per second . A program running on a computer can analyze millions of data points in thousands of stocks a second, and have sophisticated algorithms to find patterns, all backed by knowledge from decades of academic and corporate research.
Moreover, these programs can react to fluctuating prices, incoming orders, and financial news on a millisecond-by-millisecond basis. Now, coming back to you — as a human trader who has a limited capacity to read, analyze, and remember information, and has a reaction time measured in seconds or minutes, how can your level of speed and expertise possibly compete against god-like algorithms designed by incredibly smart specialists?
Okay, maybe that was too easy, maybe that only took a few seconds on your pocket calculator. To make things worse for your hand calculation, the world has about a hundred currencies, and you will need to explore arbitrages that have a path longer than length 2, both making your task immensely more difficult. The world has plenty of businesspeople who profit from your ignorance and gullibility. The potential for big profits from small investments is largely down to the use of leverage.
In very simple terms, you can use leverage to get more trading power from the capital you have. Alternatively, you could choose to buy call options on the same stock, giving you the right to purchase the stock. This is a somewhat simplified example, but it does illustrate how you can generate sizable returns from whatever starting capital you have available.
This is a clear advantage that trading options has over trading virtually any other kind of financial instrument. Quite simply, you can save money when taking a particular position on the relevant underlying security which enables you to make very cost efficient investments and trades. There are even a number of strategies that can be used specifically to reduce the cost of taking certain positions. In some respects, the risk versus reward advantage offered by trading options is closely linked to the above point.
As the given example showed, it's possible to make proportionately bigger returns from the same capital investment. We used this example to highlight that trading can be done with relatively small amounts of starting capital and it can be a very cost efficient way to invest.
In addition, options trading can offer a much better risk versus reward ratio if the right trading strategies are employed. It should be made clear that there are obviously risks involved, because there are with any type of investment.
Some trading strategies can be very risky indeed, especially those that are very speculative in nature. The general rule is that the higher the potential return, the higher the level of risk involved. What is particularly great, though, is the fact that you can pretty much choose whatever level of risk you wish to take and trade accordingly.
The wide range of different options contracts that you can trade and the different orders you can place make it much easier to limit risk than it is when simply buying and selling stocks. As you learn more about options and the way they are traded, you will realize just how powerful a tool they can be when it comes to managing risk. One of the most appealing elements of options is the flexibility that they offer. This is in contract to most forms of passive investment, and even some more active forms, where there are limited strategies involved and limited ways to make money.
For example, if you are taking a buy and hold approach to investment and simply buying stocks to build a portfolio for the long term, there are essentially only two main strategies you can use.