Think of Options Like Insurance

Options are essentially tradeable insurance contracts on stocks, indexes and some other investments. It helps to understand the concept of options if you keep in mind that options are insurance, but the terms are different. Options provide more investment options — no pun intended. The price of an option is partially derived from the price of the “underlying” investment, so you might hear someone say that she did an options trade “on the S&P 500.”

Options are useful because of their flexibility.

Options can provide diversification benefits, being used as tools to potentially enter a stock at a more favorable price, generate income on cash or on current holdings (the most common reason we trade options), manage or “hedge” risk (a close second for us), and of course, make wild speculations (we don’t do this). For example, if you believe a stock is going down (you are “bearish” on the stock), you can express that belief using an options trade that is much less risky than “short selling” the stock. On the other hand, if you want to take a lot of risk, you could express your bearish view in an even more aggressive and risky manner using an options trade.

Likewise, if you believe a stock is going up (you are “bullish” on the stock), you can express that view using options that are much less risky and tie up much less capital than simply buying the stock. On the other hand, you could make an even more aggressive bullish trade on a stock by using an option instead. There are quite literally dozens of ways to use options, and even many ways of executing the aforementioned convictions! The main thing to understand is that options are powerful and versatile tools.

How risky are they, compared to stocks?

All investments have risk, but due to the versatility of options, this question is not simple to answer. This is because you have many choices when it comes to options. One way to think of it is that options themselves are neither risky nor safe in the same way that we think about stocks. You may compose options trades that run the range from extremely conservative to outrageously speculative (read: like lotto tickets). Because of all the choices, you can make an options trade on a stock that is much less risky than buying the stock, or you could make an options trade on a stock that is much more risky than buying the stock. For the purposes of illustration, let’s consider two stocks. Stock A is very risky, and Stock B is comparatively very conservative. When you buy a stock, you assume 100% of the risk of that stock. So if you only want conservative stocks in your portfolio, you won’t buy Stock A. With options, however, you can make a conservative options trade on Stock A. You could even make an aggressive trade on Stock B!

In summary, options can be as conservative or as risky as you want them to be! They can be used to provide income, to add a layer of protection to a stock or portfolio, or to make wild speculations on the market. They’re powerful, yet versatile!

In part two of this series, I’ll discuss the three biggest mistakes people make when trading options.