Options Versus Investments – No Reason To Avoid Derivatives

An option is derived from a security

One important point to remember is that options are not investments unto themselves. They all derive from the underlying security. Therefore we call options as derivative investments. And do not be afraid of saying that word, “derivatives”. It is much frowned upon but make no mistake; it is only feared by those who do not understand it. An options value is derived from other sources and one of these sources is the prediction of the direction that the stock is going before the expiration date.

Nobody can predict where a security will be heading

I do not know why, but many investors believe that they have some special power and can pinpoint where a security is heading in a very short time frame. If it was easy like that, they would not need options, they could buy stock since they can be so accurate. They play on hunch and that is why they lose so much. We, on the other hand, will not play by hunch, instead, we will take those trades and turn into opportunities for a high-probability trade that will yield the maximum profit potential.

High profit/loss ratio? Right. But there are other factors to include when trading options

Sure, you can buy options and there are several strategies that involve buying instead of selling options. But that is not the point. I just wanted to point out how selling can have an advantage over buying options even though it has unlimited loss potential and limited profit potential. You have probably heard many times that the only bets that you should take are the ones where your profit potential is substantially higher than your loss potential. That does indeed sound like a smart advice, but let me put this way:

Would you rather go for a trade that has a 5 to 1 profit/loss ratio with 1% probability of winning or would you go for a 1 to 1 profit/loss ratio but with 80% probability that at the end of the month you will be in a winning position?

This is a very personal decision and there are lots of factors you should include in this equation. But that is just to make a point more clear: when trading options, some “sound” and commonly known concepts should be putted aside. You can buy and sell options pretty much as you would do with stocks, but they do have different end results and also do not behave the same way. So take your time and study them carefully before using them as investment strategies.