Date Last Updated: June 27, 2019

Stock Market Guide to Options Trading

There are two kinds of objectives in paying premiums for the flexibility to buy or to sell assets at fixed prices on pre-determined dates: one is to hedge on the average cost of a material used in a business over which a user company has no direct control, and the second is simply to gamble. Neither of these objectives is relevant for the average individual investor at the retail level in a stock market.

The derived value of options becomes apparent only if forecasts and assumptions hold true, and thereby yield the anticipated returns on the premium paid for an option. The premium itself can be significant for a stock market investor only if large and continuous volumes in the underlying stock or commodity are present. Because “options trading” is a highly specialized stock market transaction, most people who trade options professionally or rely upon options as an investment strategy generally build their entire careers and portfolios around such securities.

The best stock market investment strategies call for picking securities based on sound analysis and best practices such as value investing. Relying on best practices tend to lower the probability of unnecessary losses especially if investors make prudent decisions with a view towards a long term investment horizon and a disciplined money management philosophy. This type of investment approach may be fundamentally at variance with the trading options. This is not to decry options for they can give the most amazing returns on small investments, but options do not always generated anticipated or projected returns.

A major advantage of using an option as an investment tool is that they do not bind the investor per se. For example, it is quite common for an investor to forgo exercising the right to buy or sell an option contract, though the premium paid is lost. This works to the advantage of large portfolios and hedge funds with adequate risk taking margins. Speculation and hedging are cited as most often the two of the key motivations for calling options, as writers and those who “put” options are often in dire straits! Outside of professional traders, individual investors with confidence in a business model and the prospects of a well-run business with sound management would not bother with options.