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 ignorant. 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.

7 Reasons You Need a Broker Who Specializes in Options

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

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. But that’s not the case for option traders.

The Advantages of Trading Options

The most obvious difference between options and other investments is their limited lifetime. However, the most important feature of options — the one that makes it an indispensible 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.

The bottom line is that options can be used to meet the needs of anyone who trades stock, commodities, etc., and each of the objectives listed above can be attained with limited risk. There’s no need to invest large sums to buy stock.

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 some investors. Again, by hedging and accepting a smaller 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 is to point out that you can measure and reduce the risk of investing with options. 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’ll discuss the best features of various spreads and explain how to benefit by adopting them at another time.

Today, the idea is to help option rookies understand that options are used to hedge trades on a continuing basis to reduce risk. (Please keep in mind, though, that options are not perfect. If you want the combination of zero risk and guaranteed profits, you are living on the wrong planet.)

Covered Calls

One example is a popular strategy known as covered call writing. With covered calls, 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 traders also use this method. In fact, there are mutual funds dedicated to writing covered calls. 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.

Tell us what you think here.

Related Articles:

• 7 Reasons to Make Options Trading Part of Your Portfolio
• 6 Options Trading Mistakes to Avoid
• Test Your Options IQ 

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