If you haven’t already, you’ll quickly discover the sexy, fast moving counterpart to stocks — options.
It’s hard not to stumble upon these shiny derivatives. Brokerages constantly pitch them as a quick way to massive returns. (They’re also a quick way for the brokerage to generate commissions for itself.)
“Options can double, triple, or even quadruple in price overnight! And you barely need any capital to play!”
Stocks, on the other hand, appear far more boring. It can take years to realize a 100% gain and you need A LOT more capital to purchase shares.
The combination of fast moving prices and high leverage will leave you staring at option quotes like they’re a tray of doughnuts. Everything looks incredibly delicious.
[This is a guest post by Alex Barrow from Macro Ops. He co-founded Macro Ops with two other former hedge fund analysts with the goal of helping friends and family navigate these volatile markets.]
You won’t be able to stop thinking about how much money you’ll make when the option increases 500%.
But… I would caution you to fight off that urge.
Throw away the desire to buy that option like you would throw away a doughnut right before beach season.
Although options appreciate and depreciate with the price of stocks, the two vehicles are very different.
Stocks are an asset. A stockholder has partial ownership in a real cash flow producing business.
Options are merely a contractual agreement between two parties which eventually expires. That’s it. This extra time component of options makes trading them very hard. Every few months you’ll need to place new positions to continue making profits. This requires constant analysis day after day, week after week, and month after month.
Compare this to stocks where you can park money into great companies and hold for decades. Option trading is like a full-time job. Stock investing on the other hand can passively build a sizeable nest egg with little day-to-day effort.
The fact that you have to “time” market moves makes option trading incredibly difficult. It already takes plenty of skill to find stocks that will rise over time. But with an option, you have to forecast direction and time frame.
If you buy a 60 day call option on Apple, betting that the price will rise over the next 2 months, and it goes sideways, you lose everything. It’s much easier to simply buy Apple stock and let the clock work for you instead of against you. As long as Apple goes up over time, you’ll make good money. And even if it trudges along sideways, you’ll at least receive a small amount of income in the form of dividends.
Unfortunately the complexity doesn’t end there. Most traders, even the newer ones, can wrap their heads around the time component. But there’s one more layer to options that’s vastly misunderstood, even to those who consider themselves experienced operators. This component is called volatility.
Volatility influences the price of each option. When the market thinks volatility will be high, options are more expensive. And when volatility is expected be low, options are cheaper.
So on top of direction and time frame, you also need to make an educated guess on whether the volatility component of an option is too high or too low. This analysis is math intensive and cannot be ignored. Beginner option traders think they can get away with wandering into the market and betting on direction alone. But the truth is you can correctly determine the direction, yet still lose because you were wrong on volatility.
You cannot trade options without also trading volatility. The two are inseparable. Before venturing into the option market, make sure you have a solid understanding of what volatility is, how it’s calculated, and how to profit from it.
Swimming With The Sharks
There’s an old saying that goes something like this, “if you look around the poker table and can’t find the sucker, it’s you.”
This carries over to the options market. Remember, an option is a financial derivative, a contract between two parties. It’s not an actual asset like a stock.
This means you’re essentially competing against the person who took the other side of your trade. If you go long Tesla calls, another trader is taking the short side. And that trader is most likely a professional or market maker who lives and dies by his ability to execute profitable trades. Someone always wins and someone always loses after an option expires. It’s a fierce zero-sum game that resembles heads up poker more than investing.
In contrast, stocks create a “win-win” scenario for both parties. A person with extra capital transfers money to a company that can allocate that capital more efficiently and effectively.
The company improves its product with the proceeds. Consumers benefit from higher quality products. And the investor is ultimately rewarded with a return on his investment. This process is the engine of free market capitalism that has driven the prosperity of the world’s richest countries.
If you’re looking for wealth creation, forget options. Focus on taking long-term positions in great stocks that slowly grow into sizable assets.
Options trading is best suited for those who want to make a career of it. You need serious dedication to the craft to generate consistent profits. If you’re interested in beginning that journey, you can check out our free advanced options report by clicking here.