Home > Articles > Business & Management > Finance & Investing

Understanding Options

The more you understand options and how traders think about them in different situations, the better you’ll be able to understand new strategies and develop your own.
This chapter is from the book
  • He who knows when he can fight and when he cannot, will be victorious
  • —Sun Tzu

Before trading options, you need to understand the nature of options. Unfortunately, some stock traders are not exactly clear on this—or on the distinctions between trading and investing. Before stock traders can transition to options trading, they first need to know what to expect as a trader.

What Is a Stock?

A stock is a fractional ownership in a company. It is an asset, a two-dimensional instrument easily represented by a single line on a chart where value goes up or goes down. Privileges such as voting rights and dividends come with that asset ownership. But is owning an asset the same thing as investment? The average person considers an investment as money handed over to a company to make the company more competitive, which is not what happens when you buy stock. The only real “investors” are those who buy a stock during the IPO. That money goes straight to the company. After that, the stock is bought and sold among traders and not with the company unless the company executes a stock buyback, in which case shares are retired permanently. So “investing” is a misnomer for owning stocks.

The question is whether a person who buys a stock and then sells it at some point in the future is best described as an investor or a trader. The answer is not as obvious as it may seem. Investors are said to be in “for the long term,” and traders want to make a quick buck and don’t care about the company being traded. Most people only care about the company stock price going higher. In this respect, there are no such things as investors, just traders.

In order to make the transition from stock trader to options trader, you need to see both long-term and short-term trades as trades and not see one as an investment and the other as a trade. You need to let go of the aura of respectability that the term investment connotes and accept that you are a trader. Regardless of how you came to your conclusions of when and why to buy a stock, your intentions are precisely the same as those of a short-term trader: to buy low and sell high.

So where does this distinction between investors and traders come from? One answer is how the U.S. government taxes capital gains. The government wants you to be an owner of stocks and gives you tax incentives. Stock held for more than one year is considered long-term capital gains, and anything less is considered short-term. The long-term capital gains tax rate is lower than the short-term rate, which is taxed at the same rate as your earned income. The tax differences provide an incentive to hold stocks “for the long term.” Even if the government seeks to incentivize larger time frame behavior through the tax code, it doesn’t change the motivation behind the transaction itself: making money on the trade. Time frames do not matter because everybody is a trader.

I’ve encountered many people who believe that since they own stock to get dividends, which are also taxed at 15%, for now, that they are investors. Dividends are a touchy subject but let’s be clear about one thing, dividends are generally a bribe by the company to get people to buy their stock. That sounds harsh but unless the company is debt free and has more cash than it needs for future investments it probably shouldn’t be giving out a dividend. Some companies will actually go into more debt and borrow money to pay dividends it can’t afford to keep stockholders happy. This sounds like a terrible investment strategy. At best a dividend is a hedge. If a company offers a 5% annual dividend and the stock drops 8% then you have hedged your losses to -3%. We’ll look at a number of option strategies that can do much better than this.

Many people consider “investing” in the stock market as a safe bet because over time, the market goes up; so buy-and-hold is a proven long-term strategy, right? There are a number of problems with this reasoning. The first is the selection effect, as pointed out in the book The Anthropic Bias: A proper analysis of the market requires continuous records of trading of which we only have about a century’s worth from the American and British stock exchanges.

But is it an accident that the best data comes from these exchanges? Both America and Britain have benefited during this period from stable political systems and steady economic growth. Other countries have not been so lucky. Wars, revolutions, and currency collapses have at times obliterated entire stock exchanges, which is precisely why continuous trading records are not available elsewhere. By looking at only the two greatest success stories, one would risk overestimating the historical performance of stocks. A careful investor would be wise to factor in this consideration when designing her portfolio.1

Very few look at the stock market 100 years in the past. We’ve had one depression and a few recessions. Statistically, there are too few data points to draw any kind of conclusions going forward. In addition, variables—such as the demographic boom since World War II or the inflationary policies of going off the gold standard—could have more to do with the rise in asset prices than the presumption that markets will go up eventually. This is not to say that buy-and-hold is wrong, but considering yourself an investor and assuming that it is true might be a poor conclusion.

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.

Overview


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information


To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.

Surveys

Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.

Newsletters

If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information


Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.

Security


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.

Children


This site is not directed to children under the age of 13.

Marketing


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information


If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.

Choice/Opt-out


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information


Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents


California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure


Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.

Links


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact


Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice


We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020