Whether you are a trader or an investor, your main goal is to make money. Your secondary goal is to make the most amount of money with the smallest amount of risk. Striking that balance may take practice.
It is common wisdom that buying something now and selling it later at a higher price is the path to making profits in the market. But it's not so simple with options: since option prices do not always behave as traders expect them to, those who are new to this type of trading have a subtle knowledge gap, and with it a greater chance to incur unexpected losses.
Here we'll cover the tools that come with options, and how to use them to make money while keeping risk in check.
Adjusting to Options Trading
One of the major hurdles for new options traders comes from trying to trade options the same way they traded standard stock. In essence, options are really holds on future decisions: when you buy an option (on any kind of security), you're claiming your ability to decide in the future whether you'll purchase that security or not. Using options to meet financial goals can be tricky because there are many factors involved, and many branches of outcomes. You also retain a great deal of control when buying options, which, if you know how to use it, can help create outcomes in your favor.
For instance, experienced traders do not always buy stock. Sometimes they know to sell short, hoping to profit when the stock price declines. Too many novice option traders do not consider the concept of selling options (hedged to limit risk), rather than buying them.
"Selling short" is a technique of selling stock and then buying it back quickly to return to the broker; the idea is to make profits on the drop in price that happens in between.
The Greeks Mathematical Tools
Options are very special investment tools, and there is far more a trader can do than simply buying and selling individual options. Options have traits that can't be found elsewhere in the grand scheme of investing.
For one thing, they contain the Greeks—a set of mathematical tools that traders use to measure risk. This is crucial for a new trader to learn, and if you're not quite sure how or why being able to measure risk plays such a large role in trading, then think about this: if you can measure risk (i.e., the maximum gain or loss) for a given position, you can also minimize it. In other words, savvy traders can avoid nasty surprises by knowing how much money they stand to lose if the worst-case scenario occurs.
Also, traders must know how much they stand to gain, or the reward for any position, in order to decide whether seeking a certain reward is worth the required risk.
Below are a few of the ways that options traders use to gauge risk and reward potential.
Loss Over Time (Theta)
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.
Unlike stock, all options lose value over time. This is simply because options get their value from the promise of a choice to purchase something else, which expires after a given date: when the choice is made, or when it's no longer on the table.
Change in Price (Delta)
Delta measures how a change in price, either higher or lower, of the underlying stock or index will affect the price of an option. As a stock continues to rise or fall, the rate at which profits or losses occur will also change, and the option to buy a stock at a certain date will shift in value. By its nature, delta is not constant, and can be positive or negative. Some traders use delta as a shorthand way to guess how likely an option is to expire in-the-money (ITM).
Ongoing Price Change (Gamma)
The Greek gamma describes the rate at which delta changes when the price of the underlying stock changes. This is a more complex figure, since it relies on a variable that itself changes.
Tracking rates of change, and the risk that follows, 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. A new options trader must learn to deal with these changes.
A Changing Volatility Environment (Vega)
When trading stock, a stable market makes for more modest gains or losses, while a less stable market translates into larger daily price changes for stocks. In the options world, market volatility plays a large role in the pricing of the options. Vega measures how much the price of an option changes when estimated volatility changes.
Hedging With Spreads
Options are often used in combination with other options (i.e., buy one and simultaneously sell another). That may sound complex, but the main idea is simple: When you can predict how an underlying asset will behave, you can construct option positions that earn money when your expectations come true. A stock, index, or other asset may follow these market trends:
- Bullish (the price rises, by 20% to be proper)
- Bearish (the price drops, by 20% to be proper)
- Neutral (expecting a range-bound market)
- Becoming much more, or much less, volatile
There are a large number of ways to combine options, and the guidance on how to do so is vast; the most common strategies use spreads. Spread trading is when you buy and sell many options at once, which, simply put, spreads the risk of losing money over many assets. Traders who deal in spreads use the gap between prices to predict a net gain.
Spreads have limits when it comes to risk and rewards. However, by playing it rather safe, trading spreads comes with its own perks, such as a greater chance to earn (rather than lose) money; the tradeoff is that you may not see a massive windfall. A newer options trader who has some fear of taking big risks might take well to trading spreads and making a decent profit by owning a range. Stock traders, on the other hand, have nothing like option spreads.
The Bottom Line
Options trading is not stock trading. For the savvy option trader, this is a good thing because option strategies can be designed to profit from a wide range of stock market outcomes, which can be accomplished with limited risk.