Derivatives: Why Trade Options?

Traders and investors who consistently make money in the stock market don’t just rely on rising markets, they have strategies that allow them to benefit from sideways or down trending markets too.

This means they are active in all market conditions and don’t sit it out when conditions change or become volatile the way many novice investors do. Which group of traders or investors would you rather belong to?

Your answer to this question depends on your reasons for getting involved in the stock market. Maybe you are happy with your current lifestyle and income and you are simply looking for an area to invest for your future, choosing the traditional way of stock investing and holding on over the long term through the good and the bad times.

However, if you are keen to develop a system of investing and trading that can improve your lifestyle and allow you to profit from the share market with each passing year, regardless of market conditions, then it may pay you to look at the derivatives market, rather than just buying shares with the intention of profiting from capital growth.

Derivatives are financial instruments which have another asset as the underlying base and there are numerous types available to the investor, such as futures, forex, warrants, CFD’s and Options, each with a varying degree of risk.

The benefit of derivatives is that although they provide you with exposure to shares, they deliver a leverage that cannot be achieved investing in shares alone.

When you buy shares you are relying on the market to rise, whereas when you trade derivatives, you can make money no matter which direction the market is trending in. And if you think this sound’s too good to be true and only something the institutional trader may do, then think again.

Stock Options are one of the most widely used derivatives with a level of risk that can be easily managed, compared to some other forms of financial instruments that have grown in popularity over the last few years.

Why would someone trade options?

1)    By using options we can safeguard or protect our portfolio

2)    Trading options allows us to profit from falling share prices

3)    Even when the share price is trending sideways there is an options trading strategy designed to help you make money.

4)    Flexibility – instead of holding onto shares for months or years, options offer us the flexibility to make money over the shorter term

5)    When trading options, you don’t need to analyse a great number of shares. We focus only on the most liquid shares and their related stock options leaving us more free time

6)    The leverage of options can provide excellent returns from a minimal outlay. For leverage to work properly for us, we need to understand and manage it effectively.

When trading leveraged financial instruments, when you win, you win exceptionally well, but when you lose, the leverage can work against you and depending upon which derivative you choose the trade with, it could be game over for you much sooner than you think.

7)    When buying options to trade, the most you could ever lose is limited to the amount you pay to own the option

Some derivatives such as CFD’s operate on margin, which means you are actually using borrowed money to trade with. The attraction not only being more money left in your pocket and less in the trade, but the return on investment can be much much higher. What you need to be very aware of however, is that when a position goes against you, you stand to lose much much more than what you have taken out of your pocket to get into the trade initially.

You stand to lose someone else’s money as well as your own!

Regardless of which instrument you choose to trade, your technique of analysis to help you decide when to get in and when to get out of a position predominantly remains the same. There are several key factors that will help maximise your success in trading options and if you can analyse the direction of a share price or index, there is an options trading strategy that you can use to make a profit.