If you are a believer of the buy-and- hold strategy, you may want to back away slowly and make a 180 degree turn from what I am about to present. You see, I believe that trading options are the best and least risky way to invest. It’s a bird in the hand sort of thing. What has happened in the past is just one possibility of what can happen in the future. Buy and hold for twenty years. Not this guy. I want my investments short and sweat. Oh yes, and cheap.
Options and other derivatives probably get a bad rap because investors, option traders and speculators focus more on the leveraged reward options offer but lack the knowledge to control the risk side of the option equation. Fortunately, it’s just a matter of education.
There are many ways to take advantage of the tremendous flexibility of options. Some of the most common strategies employing options are: 1) To hedge an existing long or short position in the underlying equity (like purchasing insurance.) 2) To leverage a position either short or long; 3) to make a profit by selling the rights to the underlying stock. With options, a trader can make a profit when the stock is going up, down or sideways. As a matter of fact, one of the best ways to make money with stock options is to capture premiums on stocks that are range limited. But that’s a story for another day.
One of the most powerful reasons to use stock options is to leverage investment assets that can reduce shorter term risk through diversification while freeing up assets to purchase for the longer term. For example, an individual investor could use 30% of investment funds allocated for equities to purchase volatile, higher risk-reward options (volatility is good for trading options) and use the 70% to purchase positions in less volatile, long term positions.
The original development of stock options was to help provide risk management for underlying stock portfolios. Even today, a good percentage of options are purchased in volatile markets to help protect unrealized portfolio gains. This is called hedging. But as is the case today, the evolution of ways to make money (and lose it) is an ongoing process, which seems to get more sophisticated with every new development.
For the most part, new investment derivatives are developed by the professional traders in the industry and usually require not only a lot of training and experience but also continual exposure to their idiosyncrasies. This is one reason why derivatives have the tag of being risky for the average retail trader. And perhaps there is some merit in warning retail traders away from using them without proper training.
As trading options is more complex than trading stocks, bonds, or mutual funds, many investors don’t want to spend the time to become better educated on the mechanics and benefits of trading options. But as returns on most traditional investment products become anemic, investors are starting to look at options as a way to boost profits with the least risk. Options offer a very attractive way to accomplish this goal.