Day Trading

When it comes to option trading, the most important lesson to retain is an understanding of what’s actually being traded. The real commodity in any option trading strategy isn’t the underlying stock itself, and it has little to do directly with phrases such as implied volatility, net debit, net credit, strike price, or expiration date. Fundamentally, what’s really being traded when an option transaction is enacted are degrees of risk.

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Option trading, in and of itself, is not inherently risky. Options are simply tools. Imagine a big dial labeled, Options. You turn the dial one way and your risk goes down (as do your potential rewards). You turn the dial the other way and your risk goes up (as do your rewards, either in the form of upfront cash, or in the form of potential profits). In short, you can use options (for the right price) to reduce your risk, and you can use options (if the price is right) to generate lucrative income or receive other compensation in exchange for taking on someone else’s risk.

Let’s look at some scenarios that show each side of the risk trade.

Using Options to Reduce Risk

There are various option trading strategies you can employ to reduce the risk to your stock holdings. The price you will have to pay may come in the form of an actual cash payout to purchase that protection, or it may involve exchanging some of your future potential profits in order to acquire that protection.

Here are two trades that will reduce your risk:

• Protective Put – By simply buying a put, you can secure the right to sell your stock at a predetermined price. This will protect you from any big drops in the stock, but it will cost you an actual cash payment to purchase the put.
• Collar Option – The collar consists of simultaneously buying a protective put and selling a covered call on a stock you own. But instead of paying cash for the put–as in the example above–you finance the put by selling a covered call on the underlying stock. The benefit is that the protective put is purchased very cheaply (sometimes it’s even free). But the downside is that you’ve traded away any capital gains the stock might enjoy if it rises above a certain level.

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Using Options to be Compensated for Assuming Someone Else’s Risk

If you are willing to assume someone else’s risk you can be compensated–and sometimes quite handsomely–for your trouble. The compensation may take the form of sharing the capital gains on someone else’s stock, or it may simply take the form of a cash payment.

Here are two types of trades in which you are compensated to assume someone else’s risk:

• Long Call – This is a slight oversimplification because there are traders and institutions out there who engage in naked call writing (i.e. writing calls on stock without owning any of the actual stock), but in a theoretical world, a long call is essentially the other side of a covered call. The covered call writer sells the right to upside gains beyond a certain level for an immediate cash payment. In a nutshell then, buying a long call on a stock that subsequently rallies enables you to participate in the capital gains of that stock without ever owning it.
• Credit Spreads – Bull Put, Bear Call, and Iron Condors are three different credit spread trades that, respectively, assume risk against a stock’s decline below a certain level, its advance above a certain level, and its movement outside a certain range in either direction. In exchange for assuming that risk, the trade nets you a credit (i.e. cash), hence the term, credit spread.

Conclusion:

The option trade examples above are all relatively simple but they illustrate the true nature of stock options. Trafficking in options is essentially trafficking in risk. No matter how elaborate and complex an option trade becomes, the core equation of risk is still present.

Developing and maintaining an awareness of this reality of options is crucial to your own option trading success. Whether you’re looking to reduce your risk or to be compensated for assuming someone else’s, a conscious awareness of what’s really happening in any given options transaction is invaluable. Once you know what’s really at stake, you’re in a much better position to consciously look for ways to accomplish your objectives as efficiently as possible. The outsourcer of risk will seek to reduce risk as cheaply as possible, and the assumer of risk will seek the highest compensation for the risk assumed.

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