TalkFNStocks, Options and FOREX investments

As the word suggests, trading in the investments world is buying and selling of financial instruments. We differentiate between Trading and Investing by the frequency of the transactions. We define a buy-and-hold strategy as an Investment. Trading, as opposed to that, is buy-and-sell or sell-and-buy. The trading objective is to make quick gains using momentum and knowledge of directional movement as the key factors in making the trading decisions. The typical time frame for closing a trade could be anywhere between a few minutes to a few months.

We use Options as our trading instrument. Options are derivatives of stocks, commodities, currencies, indexes, etc. Basically anything that you can invest in a regulated market such as a stock exchange or a commodities market has options derivatives that one can trade in. We will not go into a detailed definition of options here, but there are several sources on the web where one can get plenty of information on options. Our objective in this note is to highlight why options are a great instrument for short-term trading. And also, why we like short-term trading.

Let us tackle short-term trading first. We believe a straightforward buy-and-hold strategy is a very risky strategy. Our belief has obviously been vindicated with the market turmoil in recent years as well as during the dot-com bust. Investors who had held stock portfolio for years and years had the majority of their gains taken away in a very short span of time. So, at the end many were back to square one. We believe that short-term trading involves risk but, if applied correctly and with discipline, can be a great risk mitigation strategy. Which investment is safe? Even a bank account that cannot even be considered as an investment was not safe for a while. It is only the level of risk that may be different.

We think that people either fall in love with a stock or do not want or have the time to spend doing the necessary research. Those are probably the main reasons why such investors do not look at short-term trading. Our question is why should an investor not sell a stock when there is a very high probability that either the market or the stock price is going to go down? What is the point of holding on thinking we will tackle the roller-coaster ride and then eventually be ok? Why not sell the stock and buy it back when it dips? Sure, one will have some brokerage costs and maybe some tax implications. But they will probably be negligible compared to the cost of weathering the turbulence in the stock price.

So, in a nutshell, our strategy is to act according to the market. When the market is telling you get out, then get out. That is why we are into short-term trading and that is what we cover here. Do not get us wrong. It is not like we do not have or believe in any long-term investments. We do and we think everyone should have some. But we think that to eke out the gains that one can in the market, one has to have a strategy that combines short-term and long-term investments.

Now let us get onto Options Trading. The biggest advantage of options, according to us, is leverage. When we buy one options contract, we are essentially controlling 100 units of the underlying stock (or instrument). That is a huge leverage. Typically, for an “at-the-money” call option, the “delta” will be 1. This means that for every $1 upward movement in the stock price, there will be an equivalent $1 upward movement in the call option premium. Since the call option premium is on a contract consisting 100 units, the $1 value increase in premium translates to a huge percentage increase on the premium. Readers of our articles on trades will know of what we are talking about.

Another reason to trade options is because one can make a play with a known risk. One pays a set amount on the premium to buy an option for a future date and one knows that the maximum loss is the amount paid towards the premium. If the option expires worthless, it is only the premium amount that is lost. As an example, if we think that a stock price is going to go up by about 10% from its current price of say $100; one way to play that would be to buy the stock. However, in order to buy 100 shares of the stock, we would have to make an investment of $10,000. Instead, the 3-month call option for a strike price of $110 may be selling at a premium of $300 per contract. So, our investment to control 100 shares of the stock is only $300. Of course, we would need the stock price to go up to $113 in the 3 months to really break even. But, on the other hand, we may not wait the 3 months and potentially sell the call option contract back in the market at a higher premium assuming that the stock price has moved in the direction we expected it to. Again, readers of our articles will know what we are talking about.

A lot of investors use options to add protection to their investment or to earn some income by selling covered calls. Again, we do not want to go into details here on these strategies but want to highlight that all types and levels of investors can benefit from trading in options.

Any which way you look at it, options trading provides significant opportunities that any investor cannot ignore especially in a volatile market such as we are in.