Three great ways to make, and lose, money with derivatives

Buying an option is tricky enough on its own, but there are a lot of other ways to play the derivatives market. Here are three lesser-known investment opportunities for traders … and how they can blow up in your face if you’re not careful.

Selling an Option

Retail investment strategies usually talk about buying options, but it’s possible to sell them as well. The advantage here is smaller, more stable gains balanced against less likely, but potentially unbounded, losses.

Want to know more about how options fit in your portfolio?

Selling the call: You agree to acquire and sell someone the underlying asset at a given price, profiting if the option closes below its strike. Doing this without already owning the asset is called writing a naked call.

Selling the put: You agree to buy the asset for an agreed-upon amount, and profit if the option closes above its strike price. (In other words, the other party agrees to buy the asset from you, hoping that its value will exceed the price you agree on.)

This flips the role of the traditional investor and, as the seller of the option, you get to set the premium at which you’ll enter into the contract. That’s your profit source in all this, keeping the premium if the other party walks away, and it can by an excellent way to avoid higher failure rate of derivatives trading.

That said if you lose you can lose big. Sell the put on an asset that plummets and you might pay out the nose for a portfolio full of nothing.

Short sales vs. Puts

Profiting off a bear market is a major part of derivatives trading.

With a short sale, you borrow assets to sell, making an agreement to repurchase and return them later on. Thus, if the price goes down, when you later buy the assets back you’ll do so at a lower price than you sold them and make a profit.

Short selling stocks is different than buying an option… Here are a few other ways stocks and options differ.

A put option is similar. You agree to sell assets for a fixed price, and the contractor agrees to buy them. Thus, if the price goes below the strike, you’ll get to sell them for more than they’re worth.

The key distinction is this: With lower up-front costs a short sale gives you the potential for more profit, but your potential for loss is unlimited if the asset goes through the roof.

A put option cuts into your profit with the up-front premium cost, but your losses are limited by your ability to walk away from the expiration date.

The Volatility Index

The Volatility Index, or VIX, is a measure of market volatility. The more frequently prices change, the higher the volatility index. Below 20 is a measure of relative stability, while any value above 30 indicates rapid price changes.

That is generally not a good thing. Fast-moving, market-wide fluctuation usually mean large losses across multiple sectors.

By trading VIX related products, such as Exchange Traded Notes or Exchange Traded Funds, you can make money directly when the index climbs. Similarly, by trading an options contract against ETN, ETF or similarly situated assets, you can create an option-hedged bet against future volatility.

The advantage is an opportunity to profit from general market chaos. Without knowing which stocks will decline you can invest in an impression of general instability.

The disadvantage is the need for highly specific knowledge. In a very real sense, you’re betting that you see something no one else does. Without sophisticated investing savvy, it’s easy for this bet to flop.

Try a few more thoughts about the role of volatility in investing…