Benefits and Risks Of Using Options In Trading
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principles that you need to learn first, the fundamentals of becoming a trader. Just about everyone reading this can run, swim, and ride a bike. If that’s the case, that means that tomorrow we could take you out to Hawaii and enter you in the Ironman Triathlon competition and it would be no problem for you to swim 2.4miles, then bike 112 miles, and then of course follow that up with a 26 mile run, rightb You see, just because you learn how to do something does not mean that you will ultimately be successful at it. Just being able to finish the Ironman is an accomplishment; huge amounts of time, energy, training, and strategy is spent on the fundamentals to participate and finish the race. Unfortunately, this is what happens to most traders….they skip learning the basics, the fundamentals, and how to utilize them to see where they are making mistakes or breaking down. Instead, most are lined up at the starting line for the Ironman and don’t even realize it. They wonder why they don’t get the results they want and get frustrated. Are you getting resultsb! We’re living through an unprecedented time of <b>…</b>
Backtested Options Trading Systems.
Benefits and Risks Of Using Options In Trading
Author: Carter Locken
One part of your brain may think that using options in trading is no different than using any other exchange-traded contract. In some ways, that part of your brain is absolutely correct: at the end of the day, you have either bought (gone long) or sold (gone short) on one specific instrument. Either that instrument will increase in value (benefiting those who went long) or decrease in value (benefiting those who went short).
However, there are considerations about the way options in trading behave as they move from out-of-the-money, to at-the-money, to in-the-money which require extra caution to properly manage the risk in your portfolio. There are also considerations about how the premium of a given option may change regardless of the underlying asset’s value, and those considerations are often what burn novice option traders.
First, their behavior if they move in-the-money. Let’s say you sell a put at a given premium: x. Now let’s say this was done in a static world where the time value and volatility component of that premium will never change, so the put will always be worth x, or, if it’s in-the-money, now x plus the intrinsic value of the put (the difference between the value of the underlying asset and the strike price of the put). The potential for intrinsic value to be added onto something you sold is what makes using options in trading seem riskier than just trading futures themselves. With a put, the maximum intrinsic value for which you will be on the hook is the difference between the strike price and zero. So if you sold a gold futures put at $1300 per ounce, and gold suddenly became utterly worthless, you would be on the hook to purchase an asset worth $0 per ounce, but you would pay $1300 per ounce. That is your maximum risk, and it’s a mighty big risk if you were intially hoping to just sell an asset, get the money in your trading account, and let it expire worthless. Also, if you sold a call instead of a put and the market moved against you, your risk is unlimited: the potential intrinsic value between the call’s strike price and the asset’s price is infinite, because the asset’s price is infinite.
On the other hand, if you are the one who bought an option (either a call or a put), you will never be on the hook for more than the premium of that option. That is why using options in trading is considered such a safe risk-management tool … but only for those who buy the options, not for those who sell them. However, even with buying an option, there is risk: namely, that the time value of the option will decay as it approaches expiration, and that other factors in the premium’s valuation may also decrease. For instance, the inherent volatility of the underlying asset may decrease, or the interest rate may decrease. These things would cause the premium to fall, and you would lose money on the premium trade itself (assuming the option stays out-of-the-money) because you bought and owned an asset that lost value.
So you can see why using options in trading, specifically buying them, is a good tool for managing your risk, but even that method won’t prevent you from ever losing money. Sometimes selling options can lead to uninhibited risk, if the market moves against you. But at their best – and properly managed – using options in trading is a great way to either protect your position in a market, or to make money from those who need to do so.
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