by Jared Levy on July 8, 2010
1. All Options are Extremely Risky
Even though options are becoming more and more mainstream, there is still a large faction of the investing crowd that believes all options are extremely risky. In fact, there are many options strategies that are less risky than the underlying stocks they derive their price from. Out-of-the-money (OTM) options may be the culprit of this misconception as they tend to be cheap and lure many new, inexperienced investors with their cost. We all know that many things in life are cheap for a reason, and while there may be a time and place to invest in OTM options, you must always use caution.
Also, be sure you fully understand what your risk is at the onset of a trade. Buying options will give you a limited risk, typically at a cost that is cheaper than buying 100 shares of the stock outright. The other mistake options traders can make is to invest as much in options contracts as they would in 100 shares of stock. While this can increase leverage, it may also increase risk. There are actually options strategies that can greatly reduce risk and volatility and while some may limit profit, they can still provide returns that many investors would consider exceptional.
2. An Option’s Behavior is Mysterious and Magical
This is another complete misconception. Again, this myth stems from inexperienced traders who don’t understand how options are priced or realize how and why options prices change. Understanding all of “The Greeks” and how they measure an option’s sensitivity to specific variables is critical to grasping the behavior of options.
Remember that options:
- Are legitimate financial products
- Are not mysterious or magical
- Perform “as advertised”
- Require work to be properly understood
3. Market Makers are Out to Get Me (A/K/A: “They” Know What I’m Doing!)