Trading options is viewed as dangerous by many investors. However, depending on each trader’s risk tolerance, the risk in options trading varies. Similar misconceptions exist with options trading. We’ll talk about these options trading fallacies in this post.
What is Options Trading?
An example of derivative security is the option. Because their price is inextricably connected to the price of another financial item, options are derivatives. In stock option trading, the trader may purchase or sell an underlying asset at a fixed price on or before a specific date, but they are not required to do so. Call and put options are used to describe the purchase and sell rights, respectively.
Advantages of options trading
Trading options have several advantages. Let’s examine a few special benefits of trading options.
- Risk hedging is possible with options trading. Your risk is reduced, for instance, if you are long a stock and you purchased a lesser put option. That is the strength of options because no matter how low the price drops, that loss still belongs to you.
- Options enable you to lower the cost of stock ownership. For instance, you may sell greater call options and earn the premium, which would lower your cost of keeping the asset, if the price of the stock you are holding is simply not changing.
- One of the main advantages of options trading is that the options are significantly more cost-effective. The trader can obtain an options position with fewer margins thanks to options.
- Options allow for the systematic transfer of risk from someone wishing to hive off risk for a fee to someone who is ready to accept that risk in exchange for a fee. This is one of the main benefits of options trading since it provides a suitable secondary market for risk, which is what distinguishes the options market from other financial markets.
- Options’ ability to offer liquidity and, in the process, promote price discovery in the underlying market is a key feature. This is a crucial function since options are a useful tool for estimating intricate risk factors.
Let’s talk about the myth and reality of option trading:
Option Trading Myth #1: Options are too dangerous
This misconception has persisted for decades as a result of certain individuals misusing options and damaging their reputations. The purpose of options was to lower risk. The idea that options are overly hazardous is untrue because they are used to hedge risk. Options are perilous if you don’t know how to utilise them, he said, but they’re not dangerous on their own, even though certain tactics are. The options trader bears the main risk.
That is to say, you may create option strategies that range from being cautious to being dangerous, and they are frequently less risky than trading equities. One of the main benefits of investing in options, for instance, is that you frequently know in advance how much you stand to lose if you’re incorrect.
Option Trading Myth #2: Options are challenging to comprehend
Options are not difficult to comprehend in and of themselves. In essence, you have the authority to purchase or dispose of an underlying stock at a certain price. The fact that there are just two choices—a call and a put—and that you may purchase or sell, is even better. You utilised call options if you’ve ever gone to the grocery store and been given a rain check because they were out of a particular item. If you have ever purchased a car insurance policy, you have purchased put options.
The tricky aspect is that choices may be incorporated into sexy-sounding tactics that are incredibly complicated. It’s advisable to stick to relatively straightforward methods while you’re just getting started, such as selling covered calls on companies you already own.
Option Trading Myth #3: Buying options is simple and profitable
Options are too tough, according to some, while others say it’s simple.
It’s really tough to earn money buying options. First, you need to determine the market’s direction correctly; while many individuals think they can, the majority can’t. Furthermore, time is a problem. Options have a finite lifespan and become worthless once they expire, so your stock needs to move swiftly in your favour. Everyone would be wealthy if trading options were so simple to do well.
The purchase of inexpensive out-of-the-money options is one of the most frequent errors committed by novices. They’re trying to transform a little bit of cash into a big fortune. The time left until the options expire becomes crucial since they are out of money. For them to work to your advantage, the stock must move before expiry.
Option Trading Myth #4: Buying options is like getting money for nothing
Selling options is incorrectly thought to be almost risk-free. Although it appears secure, selling options to get money Due to the limitless risk, selling unprotected options is a dangerous technique. The majority of the time, option sellers can profit, but when novice investors don’t properly manage risk, the few losses can be disastrous.
Selling covered calls, on the other hand, lowers risk because you already own the stock. What you give up is the chance to make a load of money. It could lead to a missed chance on a significant rally, but it is not a loss. Additionally, the covered call owner loses less in a stock decline than the shareholder.
Option Trading Myth #5: Stock market collapses are brought on by options
When the stock market crashes, many people point the finger at options traders (or short-sellers). The issues with mortgages or credit default swaps were not brought on by options. Yes, you can utilise options and other derivatives instruments to take as much risk as you want. It was greedy bankers and traders taking a huge amount of risk.
Many bankers traded with far more size (in some cases, 40-to-1 leverage) than was necessary because they had no personal negative risk. They got themselves into trouble and didn’t believe they could fail. They got into difficulties by growing too large, but alternatives weren’t to blame.
There is a widespread belief that trading options are extremely dangerous. Options don’t always include risk, but they sometimes do. Depending on one’s risk tolerance, options may be more or less dangerous. It can be used for leverage, hedging, protection, and speculation. There are several ways to profit from options, and in our opinion, the beauty of options and bespoke option strategies may even increase trading activity in the Indian derivatives market. Open a demat account with us today and start trading.