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TRADING OPTIONS: A LITTLE BIT OF SOPHISTICATION
The stock market is not only about making money. For many investors it is also a way of preserving capital, especially during periods of rapid inflation.
The vast majority of investors buy stocks -- either individual stocks or mutual funds or ETFs (exchange traded funds) -- and not having any realistic alternatives -- hold onto their investments for decades. More sophisticated investors practice diversification and asset allocation techniques by:
· Selling some stock when prices have increased by so much that the investor is over-invested in stocks and under-invested in other asset types.
· Buying additional stock when prices have undergone a significant decline and the investor is under-invested in stocks. The needed cash comes from selling the part of the portfolio in which he/she is over-invested.
There are other methods and tools that investors can use to reduce the possibility of losing money from any specific investment. That reduced-loss situation is another way of preserving one's assets.
And the tool of choice to accomplish that objective is the stock option.
The problem with options is that too many individual investors learned to fear options and never bothered to learn how they work. Each of the following gives option trading a bad name, but these do not apply to you:
· A handful of rogue traders have gambled with money that was not their own and caused irreparable damage. News coverage emphasized that these traders used options or other derivatives in their trading and helped spread negative opinions regarding options trading. Examples: Barings Bank.
· Option novices almost always adopt money-losing strategies by buying inappropriate options. In addition, they tend to hold onto those options and do not understand when to take a profit or lock in a small loss.
Investors and traders can gain an advantage over other traders when they adopt intelligent option strategies. Let me stress the word "intelligent." It is far too easy to get caught up in some "get-rick ‘quick" mindset that leads otherwise smart people into believing that options trading represents free money.
To use options as a method for enhancing your stock market returns, you must understand how options work. That means investing time and energy into an education. When you do that, you will adopt only strategies that are suitable for you and your investing objectives. If you are a long-term investor, then you should have no interest in learning about short-term trading strategies. I want to encourage you to use options to help you achieve your goals - and not as a path to wealth.
I write about more advanced strategies, but those are for experienced option traders. If you are someone who buys and sells stocks, then you can use options to accomplish these important objectives:
· Increase your percentage of winning trades (i.e., have fewer investments that lose money).
· Significantly increase profits when the stock market is trading in a relatively narrow range.
· Hedge (reduce) risk. When markets decline, you will probably still lose money with these option strategies -- but the loss will be reduced when compared with investors who ignored options.