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Options University’s Options 101 - Part 2

Filed Under Options 101 

Options 101
Part 2
 
Risk for Sale
Believe it or not, the options market was designed to allow investors to either accept or transfer risk. The options market is technically a market for dealing in risk. You’re probably wondering who would ever want to willingly accept risk. Odd as that may sound, we do it all the time.
When you buy an auto insurance policy, you are paying a fee to the insurance company. In exchange for that fee, they are accepting the risks associated with you having an accident. The insurance company is accepting risk in exchange for cash. You are paying cash in exchange for transferring the unwanted risk. The agreement between you and the insurance company creates an intangible market – the market for risk. So to answer the question of who would ever willingly accept risk, you must remember that someone is getting paid to accept that risk. If the fee is high enough, you can be sure that someone will step in and accept the risk.
This highlights why the options market is perceived to be so risky. After all, it is a market whose only product for sale is risk. As stated before, the riskiness of options depends on how you’re using them, but now we can state it a little more clearly: It depends on whether you are transferring or accepting risk. None of us would consider the car insurance market to be risky since we use it to transfer risk away from us. However, the insurance companies see it quite differently. It depends on which side of the agreement you’re on.
 
The options market works within a simple principle: while many investors wish to reduce risk, there are some people who actively look for risk. The latter are called speculators. Speculators are willing to gamble for big profits; they aren’t afraid to take a long shot if there is potential for big money. People who patronize casinos and play state lotteries are acting as speculators. If there are speculators out there who are willing to accept risk in the stock market, wouldn’t it make sense to be able to transfer it to them? Of course, in order to make it worth their while, we will have to pay them some money to accept that risk. So if there is a risk you wish to avoid, you can do so by purchasing an option. Conversely, if there is a risk you’re willing to assume, you can get paid through the options market to accept the risk for someone else. So while one investor may be using options to avoid risk, it is possible that the person on the other side of the trade is a speculator willing to accept that risk. Investors who do not understand this interplay between investors and speculators hear both sides of the story and that’s where the confusion comes in.
Unfortunately, this confusion often makes many investors avoid options altogether. This is a big mistake in today’s marketplace. As our economies expand, our financial needs increase; that’s why you see so many new financial products coming to market. Each product is different – sometimes only in small ways – but each provides the solution to a specific problem. Options allow you to selectively pick and choose the risks you want to take or avoid. And that is something that cannot be done with any other financial asset. Because you can select the individual risks to take, options can be used in very conservative as well as very speculative ways. It’s all up to you. If you’d like to make the stock market a less risky place, options are your answer. If you’d like to increase the risk and speculate more efficiently for bigger profits, options are your answer too.
Let’s get started and find out how you can improve your investments from this mysterious market.

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