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Stock Options: White Hats or Black?

Remember early TV days when the 'good guys' wore white hats and the 'bad guys' wore black?  It was easy to tell them apart.  Today, the white hats of the investment world are seen as wearing black hats by far too many.  Options.  Those are the good guys.

White hats

This post was first published at The Options Zone.

The word
‘options’ evokes a negative emotional response from people who never use them,
don’t understand how they work, and who prefer to remain in the dark.  Many investors truly believe that options are
risky investment tools, used only by high-rollers.  Thus, they make no effort to see ‘what all the
fuss is about.’  Surely they know that
huge numbers (several billion per year) of options trade, but they have no
curiosity.  Why?   I’d guess that an uneducated broker once
told them that options are ‘dangerous’ and are too complicated for the
individual investor to understand.  The
truth is that those stockbrokers were unwilling to learn, and provided a
disservice to their clients.

Today, the
world is more efficient, with useful information (along with misinformation and
hype, so please be careful) all over the Internet.  Options Zone is a safe place to learn about
options, and that’s the reason I accepted an invitation to participate.


Those of
us who understand how options work reap the benefits.  Those who prefer ignorance, must trade with
much more risk than necessary.  For most
investors, bull markets provide profits and bear markets bring the realization
that investing is not a gimmie.
Options are unique.   

The
first obvious difference between options and other investments is their limited
lifetime.  However, the most important
feature of options – the one that makes it an indispensable investment tool –
is that options allow an investor/trader to measure and manage risk. 

  • If you choose not to be hurt during a bear
    market, you can own insurance against large losses
  • If you prefer to use leverage, you can attempt
    to turn a small investment into many times that amount.  This is the ‘gambling’ aspect of options
    that I don’t recommend – but it’s your money and you make the decisions
  • You can own an option position that benefits
    when specific stocks, or indexes, trade in a narrow range.  Or you can own a different position that
    earns money when a specific stock moves much higher or lower
  • Whatever your outlook for the market – bullish,
    bearish, neutral – there is a hedged options trade that earns a profit if
    your outlook becomes reality.  NOTE:  This sentence is not what the hypesters say.  Their line is 'you an make money in any market.'  Sure, but you have to be correct in your forecast.  You cannot take a bullish stance and expect to profit when the market crashes
  • The bottom line is that each of these objectives
    can be attained with limited risk.  There’s
    no need to invest large sums to buy stock. 
    Options can be used to meet the needs of anyone who trades stock,
    commodities etc.

When you
own options, the passage of time is your enemy. 
But you can earn a profit when your prediction comes true.  By hedging the trade and accepting a limit on
profits, ‘time’ risk can be cut considerably. 
When selling options, you earn profits as time passes.  However, other risk factors make this idea
too risky for most investors. Again, by hedging and accepting a smaller limit
on possible profits, that risk can be cut dramatically.

My
purpose today is not to compare the advantages or disadvantages of adopting
various option strategies.  Instead it’s
to point out that you can measure, and reduce, the risk of investing.  That’s why options are special and worth the
time to understand how they work.

More
experienced option traders know better than to try to make money by constantly
buying or selling options and predicting how the market will move.  They understand how difficult it is for the
vast majority to have an inkling of what’s coming next in the stock markets of
the world.

These
investors trade spreads, or reduced-risk, hedged positions.  I’ve discussed the best features of
some basic spreads and explained how to benefit by adopting them (see 'categories' in the right-hand column).

Today,
the idea is to help option rookies understand that options are used to hedge
trades – on a continuing basis – to reduce risk.  Note: options are not perfect.  If you want the combination of zero risk and guaranteed
profits, you are living on the wrong planet.

One
example is the popular strategy: covered call writing.  Investors earn profits when the underlying
stock moves higher, holds steady, or declines by a small amount.  It’s very popular among new option traders,
but serious, experienced investors also use this method.  In fact, there are mutual funds dedicated to
writing covered calls.  The point to be
made is that this method comes with risk. 
If the market tumbles, covered call writers perform better than those
who simply buy and hold the same stocks. 
But, by using options judiciously, risk can be reduced even
further.  By varying the specific options
traded, the covered call writer can enhance the upside or gain additional
protection against a downside move. 
Options are versatile investment tools.

Option
strategies can be used to reduce risk and enhance the probability of earning a
profit.  The profits may be limited, but
the combination of more winning trades and smaller losses is appealing.  Only options can do that for an individual investor.

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Lessons_Cover_final Are you a fan of Options for Rookies?  Have you benefited by reading
this blog?  Are you one of the many readers who has sent congratulations
and thank you messages for proving valuable content? 

I thank you for the kind words of encouragement.

 


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