This article will address the importance of diversification among instruments when trading options. Although there can be various types of diversification, including using different option strategies, the purpose here is to discuss diversification among underlying products.
I found the following e-mail in my mailbox from an Online Trading Academy newsletter subscriber:
“Hi Josip,
I just started dabbling with options and don’t know where/how diversification fits in with options. After all, I could just lose what I paid for the options, right?”
This e-mail indicates that the student trades only long options, either a long call (+c) or a long put (+p). In such a case his assertion is accurate. However, there is a need for deeper understanding of the market and the products that are being traded if one seriously wants to trade for a living. One of the easiest ways to start building a base of knowledge is to start with the simplest and most fundamental principles: How does the stock market operate? Although I do not intend to spend the rest of this options article on an in-depth explanation, a short one will be provided.
After the discovery of the New World, European countries would set up new colonies with the goal of extracting valuable goods and bringing them back home in order to earn profit. However, bad weather, poor navigation, or even pirates could pose a threat to these enterprises. To offset these possible setbacks the ship-owners would find a number of investors and sell them part ownership (stock) of these enterprises. The new stock owners who helped to finance the voyage’s costs would, when the ships returned, share the profit according to the size of their share holdings. To help increase the chances of success some investors would invest in multiple enterprises, several ships at the same time. In such cases their risk was spread, hoping that at least one ship would safely return providing a pay back greater… Continue Reading
