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The Expanded Role of Options in the New, Modern Market

By  Mar 15, 2012

Topics: Finance & Investing

In the 1940s the average holding period for stocks was as high as 10 years. This is unheard of today. Now the average is down below one year and many active traders (day traders, swing traders) are looking at being in open positions for a matter of days, not even weeks or months.

With this new "normal" (created in part by access through the Internet, very cheap trading costs, and markets characterized by high volatility), do options play a role?

In fact, they can. Options are flexible, much cheaper than stock, and can be used to manage and reduce risks. For example, a bearish trader may short stock but that is a complex, expensive and high-risk strategy. As an alternative a long put gives the trader control over 100 shares for a much smaller market risk. The typical at-the-money or out-of-the-money option with less than a month to expiration is going to cost less than 5% of 100 shares of stock.

Do active traders benefit by using soon-to-expire options to actively trade? Yes. Considering that the typical holding period is extremely short, options expiring in less than one month are very cheap because most of the time value has already disappeared. So options provide leverage and diversification, not to mention much lower risks.

Many have already figured this out. Take a look at the CBOE stats on option trading. In 1979, when puts were publicly traded for the first time, over 39 million contracts were traded (up from only 1.1 million in calls four years earlier). By 2009, 3.6 billion contracts traded, and each year's growth rises to record levels. Clearly, options are going to play an ever larger role in the future.

In the past, investors were mostly concerned about a stock's historical volatility. Today, the game has moved to the option's implied volatility. This is where you can find great values, quickly and easily, reducing risks and finding the value trades. Write to me with comments, suggestions, ideas or questions: thomsett@conservativetrade.com

Michael C. Thomsett (thomsett@conservativetrade.com) is author of FT Press’s “Options Trading for the Conservative Investor.” He is an instructor with the New York Institute of Finance. He teaches five  courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.”  He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com