Options have been in the market for close to fifty years, but they have recently gained attention. With more investors intrigued by the concept, it is relatively considered that these sophisticated investments can significantly impact the market’s efficiency.
Options traders do not boost market anomalies. Options are considered as a stable, hedging mechanism to keep investments safe during different market conditions. The lack of immediate impact and availability of strategic alternatives ensures the limited capabilities of options traders.
This article explores the definitions of options trading and market anomalies. It indicates the effects of anomalies on the market. A comparison of stocks and options is also provided to help you decide the best investment choice towards the end.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Is Options Trading?
Options are contracts that allow investors to buy or sell underlying instruments at a specified price over a specified time. Instruments include ETF, index, and securities. Over a predetermined time, this exchange is carried out in the options market, where securities are often used.
You have the opportunity to avail of a ‘call option’ which allows you to purchase shares at a later date. On the other hand, the ‘put option’ is purchased to be held and then later sold at a predetermined time.
Options are a cost-efficient investment that ensures a safe return. It has high potential and can lead to significant gains if dealt with precaution. Options do not represent the ownership of a company, like stocks.
Options are the safer option when compared to futures as they can be liquidated. You can easily walk away from options that make them a low-risk investment.
Buying or selling options indicate authority until expiration. This is why the system of options trading is termed as derivative securities.
It means that the price of options is derived from the value of different assets such as securities, other underlying instruments, and even the market rates. The check and balance in this trade make options a safer option when compared with stocks.
What Are the Market Anomalies?
Anomaly literally means an unusual occurrence. In financial markets, the term is used for situations where securities perform in contradiction with efficient markets’ principles. When the price of a security reflects all available information at any point in time, that is where anomalies are usually recognized.
The dissemination of new information at a constant and quick pace hinders an effective market from reaching its goals. The market anomalies vary in terms of their duration and type. Here are a few different kinds of market anomalies:
Calendar Effects
All market anomalies of time are flagged as calendar anomalies. The most common effects include the calendar effect, weekend effect, turn-of-the-month effect, turn-of-the-year effect, and the January effect. The negative balances on Monday and the challenges of over-optimism in January tend to impact the stock market severely.
The tax calendar aligns with the buying and selling of securities to offset gains for tax purposes. Usually, the small-cap stocks benefit from the sugar-rush experienced in January to step in the stocks game again.
Ill-Timed Announcement and Their Effects
The announcements of earnings, mergers, acquisitions, and stock-splits can also cause significant market anomalies. While the stock price most rises after a stock-split, many companies issue splits when the stock price is too high to be purchased by the average investor. Empirically, the split-stock effect has revealed that the stock prices will only continue to rise.
The announcements often dictate the movement of stock prices across the charts. The short-term price drift occurs when the stock price fails to reflect the announcement about its progress.
Merger arbitrage is another market anomaly that deserves to be mentioned here. When a merger or acquisition is announced, the stock price of the company being acquired rises while that of the bidding firm falls. The merger arbitrage depends on the mispricing that follows the announcement of the merger or acquisition. The arbitrageur’s objective is to take advantage of the usual bidding patterns for premium rates on target firms. This gap leaves the market unstable for a short period.
Furthermore, some superstitious anomalies arise from non-market signals. The Super Bowl Indicator for winning football and higher closing for the year may seem silly, but it has proven to be accurate multiple times. Similarly, the Hemline Indicator about the length of skirts is an equally outrageous thought.
Many people believe that the length of skirts indicates the position of the market. It is believed that when skirt lengths rise, the market starts topping and has a celebratory closing. The ‘Bare knees, bulls market’ theory became popular after 1987. The market had immediately crashed after miniskirts were swapped with the long skirt; the indicator has since festered and stayed.
The Effect of Anomalies on the Market
The anomalies in a market should not exist in the first place, but if they do, then persistence must be avoided. Anomalies usually don’t have conclusive explanations, so it is necessary to keep them far from the market.
It is safe to assume that an anomaly reflects the inefficiency that underlies any market.
Profitability from an anomaly lasts for a short time only. Exploiting anomalies continuously will only initiate an opposing movement. It will take a long time to resolve in the future. In the unlikely event of anomalies forming a calendrical pattern, profits will wane, and returns will be adjusted with risks to determine the market’s new rhythm.
Options do not impact market anomalies because of their limited capacity. The option trade is usually maintained at safe levels to ensure returns for all the investors. The low-risk and high-gain potential of this investment option makes it the perfect choice for those who are willing to diversify their investment portfolio.
What Is the Difference Between Options and Stock Trading?
The most significant difference between options and stocks is the representation of ownership in the company. While shareholders own a public company, options are contracts signed with investors to indicate a stock price direction. The difference in ownership is of no value when these assets are compared to a portfolio.
Many investors get over-excited about the opportunity to purchase options and stocks. This often leads them into financial straits that can be easily avoided by doing a little research on low-cost index funds and other such alternatives. It is also essential to look at both options and stocks from a long-term holding perspective and a short-term trading point of view. Your end-goal is the best barometer for what you should invest in.
Options vs. Stocks: What Is Better for You?
Choosing between options and stocks is a personal decision dependent on your long-term goals for the investment portfolio. If you prefer straightforward trading, then stocks will be the ideal choice for you. Stocks are the perfect option for those who enjoy observing the trends in the market.
Options, on the other hand, are unresponsive to such trends. They are a steady choice providing a hedging mechanism to keep investments safe. Call options inadvertently lead the trader towards stock investment.
The key takeaway here is to be aware of your decisions. Taking a little time to consult with a professional will help you gauge the right time for an investment. It is advised to know the pros and cons before entering the market as an inexperienced investor. The chances of ill-informed manipulation are too high in such cases.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
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- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
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Conclusion
Options are derivative contracts used as a hedging device for risk-management. They are a low-cost choice for investment that can be lengthened and shortened according to their preference. The little to no downside makes options a brilliant zone for exploration. The flexibility of the contracts ensures that options remain profitable under all market conditions. They continue with stability even during periods of an anomaly.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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