Option Trading - As Risky As The Reputation?...

Options Trading has a reputation for being extremely risky, but this reputation is in large part undeserved. True, option trades are extremely risky - even dangerous if you have no idea what you are doing. However, that is true of all forms of offline or online trading, and trading in options is no exception.

While options trading has this reputation among laymen, it is often considered to be a form of risk limitation with professional traders. After all, in what other form of investment can you guarantee the maximum loss you can suffer right at the point where you enter the trade?

Options are contracts that give the purchaser the right to buy or sell an underlying security, such as a stock, a bond or a commodity, at a fixed price and for a fixed time period only. You can find options on underlying securities such as stocks, mutual funds, bonds, commodities, and more.

Option trading gives you the chance to exploit a whole range of market opportunities that are unavailable with conventional online stock or forex trading. For example, one class of option trade allows you as the buyer to make money if you expect the market to move strongly in one direction or the other, but you are not sure in which. If you are the seller of position, by contrast, you are betting that the market either goes nowhere directionally and/or the volatility declines.

Trading in options can actually lower your risk. For example, whenever you buy an underlying stock, there is always the extremely small, but non-zero, risk that the company can go bust and the stock price can first be suspended and then go to zero. That means that your potential loss is the point difference between the price you entered the stock trade and zero, multiplied by the number of shares you own! If you had done the corresponding option trade by contrast, i.e. buying call options on the stock, your loss would be simply the price you paid for the options.

Where options are very risky is where untrained traders go "naked short", as it is called. In one common example, they sell put options on a stock index future and collect the option premium as payment. This gives the buyer the right to sell the stock index future back to the put option seller at a fixed price, called the strike price. This is fine as long as the underlying index continues to rally and the strike price is basically never reached. However, in one famous example, one hapless option punter, who had been happily selling put options on the FTSE index futures for years and collecting the cash, got badly caught when the entire stock market crashed in 1987, and the option buyers exercised their right to sell their positions at prices much higher than the current market!

However, such foolishness apart, option trading can be an extremely profitable way to trade in stocks, forex, bonds, currencies or whatever. When used properly, they can actually limit your risk drastically. Option trading can allow you to create positions and exploit market opportunities not otherwise available. Best of all, if you combine options with the underlying instrument, you get to create a whole range of interesting risk profiles.

The key to success in option trading is, as with anything else in life, to study the subject hard before trying to trade and, if possible, begin by paper trading the market. Once you are satisfied that you know what you are doing and have a valid option trading methodology, then you can begin risking real money. Even then, you only trade very small to start with and with money that you can afford to lose. Once you know what you are doing, and your account size show some nice profits, then you can afford to trade progressively larger size for progressively larger profit.