Each year thousands of people pile into hotel seminar rooms to learn about stock options. Many dream about earning incredible returns on each trade, quitting their day job, and spending their work day casually trading from the comfort of home.
It typically does not work out that way, however.
Making money in the stock market is a challenge. If you lived through the 2000-2002 bear market or even the market crash at the end of 2008, you realize how quickly a stock portfolio can be decimated. While options do allow you to protect against such market down turns, even profit from them, these are derivative products and, consequently, are that much more difficult to manage.
The two or three day hotel seminars typically focus upon option basics and individual option strategies. While learning the basics is always a good start, it does not provide you with a complete picture of what it takes to actually make money as an options trader.
Typically, successful traders do not focus on one or two options positions. They tend to trade a diversified portfolio of trades, which they select and manage based upon the totality of risk factors present in the portfolio as a whole. In other words, they do not care about an individual trade making or losing money. What they care about is the health of the overall sum.
If you have invested in stocks, mutual funds, or other equity products, you are likely aware of the concept of diversification. In the context of a stock portfolio, traditional advice would warn who about "putting all of your eggs in one basket" and encourage you to own many stock from differing sectors. The theory is that trouble with one stock will have a limited impact upon your overall wealth.
Yet, most stocks tend to move in tandem with the market. In fact, the more diversified a stock portfolio becomes the more likely it is your wealth will rise and fall with market fluctuations. Consequently, as a stock investor, it is very difficult to manage risk short of liquidating positions and moving to cash during market downturns.
Options open up new possibilities, however. These derivative products gain value and lose value based upon a series of factors; not just the rise and fall of stock prices. Complex mathematical formulas have been devised to predict the price of an option given a set of variables. Those variables include things like the price of the underlying stock, the number of days until the option expires, and market volatility.
Each variable in the option pricing equation has been assigned a "Greek" letter, or at least a letter that sounds "Greek." For example, "delta" represents the amount by which an option will gain or lose value given a $1.00 rise or fall in stock price. If an option has a .40 delta, that option will capture 40% of the stock's movement, gaining 40 cents if it rises one dollar and losing 40 cents if it falls in price by one dollar.
Options also tend to gain and lose value when market volatility rises or falls. As markets become more volatile, option prices tend to increase. They lose value when markets become complacent. Passing time will also reduce the value of an option.
Understanding how these "Greek" variables allows an options trader to assess their relative position in the market, identify where their risk lies, and take action to manage the overall portfolio regardless of market conditions. Professional traders perceive their portfolio in the context of these variables and then execute trades that enhance their overall position. Effective management using the Greeks can generate monthly profits whether the markets move higher, drop in price, or remain range bound.
Managing a portfolio "by the numbers" in this fashion transforms the trader into a risk manager. They simply look to the Greek variable, which immediately tell them where the risk are in their portfolio. Once they identify the risk, a trade can then be executed to bring balance back into the overall asset mix. Done properly, that "re-balancing" will typically enhance potential profitability.
This tends to be a very methodical and low stress manner of trading. In fact, it is much like running a business as opposed to the mythological fast paced "shoot from the hip" lifestyle we tend to associate with traders. The result is a highly risk averse portfolio with significant potential for extraordinary returns.
[expert=Christopher_Smith,_J.D.]
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