Is trading options without simulating and understanding their behavior a good idea?
In the blog post below we look at the pros and cons of jumping in options trading without practicing before. Out there broker dealers offering CFDs or future contracts have mushroomed. And so did the mobile trading apps. You can even trade ETFs and fractional shares nowadays, so why not try some knock-out options? After all, they are not so different from stocks trading, aren’t they?
We have all been there: you want to profit from the stock markets, so you open a broker demo account and start buying and selling shares. Then you open a crypto account which (especially nowadays) advertises futures on bitcoin. Why not? (again)… Aren’t the crypto futures simply leveraged contracts?
In a nutshell, yes and no.
What are derivative contracts?
Derivative contracts are financial contracts which move in sync with a traded financial instrument, be it a stock, a commodity or a crypto. What differentiates a derivative contract from other instruments is the leverage – its ability to magnify several times the movement of a financial instrument.
This derivatives behavior looks simple at first sight. But it presents actually several issues.
First of all, derivatives move much faster than any stock or crypto. Say you buy a contract with 5x leverage on bitcoin – every time bitcoin moves with 10%, the derivative moves with 50%.
Secondly, derivatives have rarely an indefinite life – and the contractual conditions which come in fine print actually limit a lot their movement. Let’s say that you think that bitcoin will double in the next 2 month, so you buy a long 10x future contract on bitcoin.
(Short explanation – a long contract means that the future’s value increases together with the bitcoin’s value – for you, the contract’s buyer. So this means that you the futures buyer will profit when the value of bitcoin increases.)
What could happen in reality would be that bitcoin goes first down by 20% before going up 50%. The specifics of the derivatives mean in this case that the contract value will go to zero first, eliminating any chance for profiting.
First lesson that most options traders learn on their skin / capital account: for derivatives, the time frame for trading (and the moment you enter a trade on a broker’s contract) are very very important.
Possible solutions to the derivative issues
You as a newbie trader might get lucky and get profits from trading derivatives. Or you might be not so lucky and loose all your capital before you would (paper trade) make any money. It happened to most of us traders out there – and it happened more than once.
So what can you do?
First of all, read the fine print of the derivatives contracts that you are buying. No matter if you trade futures, options or some instruments in between, take your time and read the conditions out there.
Secondly, use a derivatives trading simulator. Before entering any real trades, it is always a good idea to choose a specific traded instrument and simulate what happens when the stock’s value moves up or down. With +10% or -20%.
I know, this takes time. And even worse, there are very few tools out there where you can properly simulate derivatives trading. But still, if I may leave you with any advice – take your time and read the fine print, before launching that 500k long future contract on bitcoin. You will not regret it.