How not to use options

January 5th, 2007

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Many people have the impression that options are ?risky? because they expire after a cut-off date. Though this impression is understandable, it indicates a misunderstanding on the use of options. As a result, options are often misused, resulting in losses?that is where its bad reputation comes from.

To elaborate on how options are misused, we first look at how people trade stocks. It is easy to understand how to profit from stock trading?buy low and sell high if you believe that the stock price will rise. If you believe that the stock price will fall, you can short-sell?borrow stocks at high price, sell and then buy back the stocks at lower price later to return the loaned stocks. In other words, to profit from stock trading, you only have to get the direction of the stock movement right (though not exactly so for short-selling, but the idea is there).

Now, when you extend this idea to options trading, it becomes a recipe for losing money. Since options have expiry dates after which it becomes worthless, getting the direction right is not enough?you have to get the speed of the stock movement right as well. Since it is hard enough to get the stock?s direction right, let alone its speed, using options as if it is a proxy for stocks will result in increase likelihood of suffering losses. Also, options prices also depend on other variables in addition to the direction of its underlying stocks (the stock that the options derive from). In real life trading , it means that in some cases, it is possible for an option?s price to fall even though the underlying stock price remained unchanged.

Thus, if you are intending to trade options the way you trade stocks, we urge you to think twice. To trade in options, you need a paradigm shift from your understanding of conventional stock trading. We will touch more on that later. For more information on how to trade options safely, we recommend the books in the Derivatives section of Recommend Books.

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