Much of the focus here is on discussing the most basic options concepts and building from there.
The other main focus is on guiding your understanding of how options work. That knowledge allows you to use options effectively.
It’s easy for someone who considers themself to be an options educator to tell people that they should buy call options when they expect the underlying stock price to rally and to buy puts when they anticipate a decline. However, that would be a massive disservice to those readers. There is much more to using options than guessing whether stocks will move higher or lower. By the way: profiting from that guesswork is far more complex than it seems.
Options were invented as risk-reducing tools. More specifically, they were created to shift risk from those who want to avoid too much risk to those willing (for a fee) to accept that risk. If this sounds as if options can be used as insurance policies, that is because they can. Most newcomers to the options world never get introduced to that risk-reducing concept and thus end up using options as a gambler would. We encourage you to use options as someone who wants less risk when investing in the stock market.
The final decision on how you use options is yours. Our job is to ensure readers understand the difference between speculating and hedging risk — so they can make intelligent decisions. Thus, most articles refer to ways to generate profit with less risk (i.e., less money on the line).
If you prefer to speculate, then consider learning how binary options work.
Risk Avoidance vs. Speculating
When you buy homeowners insurance, you bet with the insurance company. For a fee, also known as a premium, the insurance company guarantees to provide money to replace your house if it is destroyed. You don’t expect to win the bet. You hope that the insurance policy expires unused. However, you buy insurance when you cannot afford to replace your home if the unexpected happens. So you buy insurance for the peace of mind that it provides.
A risk-averse stockholder can do the same. By paying a premium to buy a put option, the stockholder is guaranteed (for the option’s lifetime) that the stock’s value cannot fall below a specific price level (the strike price of the option). As often happens with homeowners insurance, time passes, the insurance policy lapses or the put option expires, and the cost of insuring the property is lost. The question for most people is whether that cost was worth the peace of mind that it provides. The answer is almost always ‘yes’ when dealing with a home.
The point of this discussion is to be sure that you are aware of that.
- Put buyers tend to come in two varieties—Conservative investors who own stock and aggressive traders willing to bet that the stock price will decline.
- Put sellers are almost always speculating (this is not the time to talk about exceptions) by betting that the stock price will not decline, or at least that it will not decline by enough to result in a monetary loss.
Covered Calls
To reduce risk when investing, several options and strategies should suit your needs—including writing covered calls and selling cash-secured naked puts. We must mention that buying puts as insurance when you own stock is not a good choice. It is a popular choice because investors don’t try to understand options as well as they should before making their first option trades.
If you prefer speculating, we encourage you to recognize the risk involved. The main point is that you should avoid taking an unlimited risk when limiting risk with every trade is so easy.
