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What Is Option Trading and How Risky Is It?

May 31, 2012 | Comments: 0 | Views: 97

Option trading sometimes seems clouded in secrecy, when really it is a straightforward means of investment, employed by large investment companies and by individuals.Sometimes, the world media takes delight in spreading the fear because a wayward employee has made secret and stupid investments using derivatives such as options, and thereby lost a huge amount of money. This type of press exposure has resulted in options trading having a bad reputation.The reality is that most responsible traders use options as a means of alleviating risk, not increasing it.

How does this work?An investment firm, say, may have purchased a large number of shares in a particular company for its clients.If the market crashes for some reason or another, this will have an effect on the prices of this company's shares, even if the company is fundamentally sound. Most investors will attempt to sell the shares as soon as possible, but often cannot find a buyer to stop the carnage.However, if the investment firm buys a 'put' contract on the shares that it owns, this gives it a solid guarantee that they will be able to sell the shares at a certain fixed price, even if those shares are trading much lower at the time.In effect, the firm is buying a form of short term insurance to ensure that its investment is protected to a certain level.In this way, it protects its clients from heavy losses, and at the same time protects its reputation.

On the other hand, say a major company such as Sony plans on producing a new widget in the near future. The expectations can create quite a lot of interest in the stock, and share prices grow as a result.In this case, an investment firm may want to buy up large blocks of stock for its clients, but at the best possible price. So, before the frenzy starts, the company may purchase the right to buy the stock in the future at a set price (this is called a 'Call Option' contract).This then is a guaranteed price that it can pass on to their clients.Naturally, if the stock has increased in price over that period, the clients will benefit from the foresight of the investment company, and will make an immediate profit.If, on the other hand, the price is lower, the firm will simply allow the option to expire, and buy the stock at the lower price.Either way, it ends up with the best possible trades for its customers, and of course its reputation is protected.

Individual investors can use options in exactly the same way as major investment firms, although obviously in much smaller quantities. In some ways, it is not too different from taking out a mortgage to buy a home. You use a small amount of your own money, combined with the bank's money (which you don't actually ever receive or touch) to control the ownership of a property much more expensive than you can afford. If the housing market grows, you get the full benefit of the growth, even though your own financial commitment is relatively small.This is the principle of leverage. You can use options to control ownership of large blocks of stock that you don't ever actually need to own, and you can also protect stock you already own from large market fluctuations.

The real beauty of options trading is the flexibility.Instead of buying 'insurance' for your stock in case of market fluctuations, you could sell options, and so become a form of insurance salesman. You can even do this with combinations of different options contracts to ensure that you are protected as well. These types of strategies (with crazy names such as 'credit spreads', 'iron condors' and 'butterfly spreads') are simply variations on a theme, designed to gain value while minimising risk.

Each strategy has its own characteristics, and its own risk profile, but it is worth learning about them and using them. We are often advised by investing gurus to protect our capital by diversifying our investments, but what about diversifying our investing strategies as well? Getting started with option trading is nor hard, but you will need to do some learning and some practice trading so that you can get the concepts clear.

Source: EzineArticles
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