Speculating in Options-Why Trade Options?

Although options are often used to trade the direction of the market, perhaps one of the main differences between an option and an outright is in the view of the trader. Options are ideal for trading the volatility of the market whereas outright positions are ideal for trading market direction.

Some traders have made considerable sums of money trading the volatility of the market with options even though they have not had any strong opinion about the direction of the market. Other traders who have had a correct opinion about the market have lost money in options because they did not understand the implications of how volatility affects the pricing of options.

Options can be traded with a strong view about volatility, but not necessarily a strong view about market direction. However, the converse is not true. Options should .not be traded on market direction without an understanding or feeling for the volatility of the market.

The trader who uses options to trade market direction must also have some concept of the time of the move, as well as how volatile it will be. Otherwise the trader may be right about the direction, but lose money in the option because of volatility and time considerations. How could this happen?

Don is bullish on the market trading at 100. He buys a 105 call at 5. The market eventually rises to 105 at expiration, but the call expires worthless. The market went up but not high enough to yield a profit in the option. He was correct about the market going higher but incorrect about how volatile the market would be.

A trader who is correct about volatility but wrong about direction can still make money. How could this happen? Joseph is bearish on the market which is currently at 100 and he believes it will drop to 95. He also feels it will not move appreciably so he sells a 105 call for 5. The market does not sell off but instead settles at 100 on expiration so the call expires worthless. He makes 5 on the call because the market was not volatile and did not move in any significant direction. He was incorrect about market direction but correct about his assumption on the volatility of the market and was still able to profit.

Between these two extremes are traders who are not trying to predict market direction but have a sense of volatility. For example, Barney has no opinion on market direction but believes it will move In a strong manner soon. He buys a 100 straddle for 10 points and will make a profit if the market goes below 90 or above 110. If he feels the market will settle down and not move greatly he may sell the same straddle and the profit and loss potential would be reversed. In either case, he does not have a strong feel for market direction but does have an opinion about volatility.

Some option traders can simply trade market volatility and always remain delta neutral, thereby not taking outright positions in the market. The option trader who has a reasonable feel for the market and a good understanding of volatility will have a far greater advantage than a person who only has an opinion about market direction. The trader must understand how the price of an option is derived and the factors which affect the value of an option, and then decide the best strategy to employ when using options.

Many people find options appealing because they feel options offer "unlimited" profit potential with limited risk. This feeling is partly true but remember, the limited risk and tremendous profit potential come at a cost in the option premium. Buying an option provides a means to participate in a move in the market without the corresponding risk of the market moving severely against you. Selling options allows the investor to profit if the volatility of the market drops.

Options are another way to change the risk reward characteristics of a trading strategy. They are also a means to trade the market in different ways, and so, offer the trader more strategies and possibilities. Options are perhaps best viewed as another type of important trading method. Just as there is a time to go long and short the market with outrights, there are also appropriate times to buy or sell options. Options provide many more options to the intelligent trader.