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I'm currently trying to understand why anyone would trade options contracts speculatively. So far I've found 3 possible reasons:

  1. Because the underlying asset cannot be traded directly (i.e. you can't directly trade wheat without taking physical delivery).
  2. To leverage their position
  3. "Options may be used conservatively to create a position with the same profit potential as the underlying asset, but with less risk of loss"

With regards to the first of these points, I can understand that in a minority of cases, this may be a valid point. However, you still hear of people trading futures on stocks, currencies and tradable assets.

The second of these points does not explain the practice either, as most brokers offer customers the ability to leverage their positions when trading an asset directly.

The third point is something I have read online, and I assume that it must be false, since it would otherwise contradict the no arbitrage principle.

So what reason is their to trade options contracts speculatively (rather than just trading the underlying asset directly), presuming that there is a market for the asset.

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    $\begingroup$ Making a bet where the maximum loss is limited (albeit 100% of what you paid for the option) is attractive to many people. This is not really achievable in the real world by trading the underlying (due to jumps). $\endgroup$ – noob2 Jan 22 '18 at 21:14
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You are confining your perspective to just the delta or directional bets on equities. There are other bets that are embedded in options besides delta. The most obvious is the bet on volatility. Being long options will allow investors to take a view that the volatility of the stock will be greater than where this is trading currently.

There are two ways to benefit from an increase in volatility--(1) the actual volatility (gamma) increases above the price (implied volatility) and/or (2) the price of volatility goes up (implied volatility increases). And example can be found here: What really is Gamma scalping?. Relatedly, there may be some skew benefit to being long the options--in equities, this tends to be on the downside on stocks.

Others might prefer to sell volatility (implied volatility) and extract the "volatility premium" as an additional source of potential income and extract the theta. Implied in this is the roll down if there is a upward slope to the term structure of volatility.

And yet still others are benefiting from using options in other hedged strategies.

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  • $\begingroup$ curious - if you wanted to be long volatility wouldn't you be better off adopting a trend following strategy in the underlying assets? we know that systematically being long vol (in equities at least) tends is a money losing strategy $\endgroup$ – Michael Feb 2 '18 at 18:14
  • $\begingroup$ @Michael: These are different bets. You are describing a momentum trading strategy. You can be long volatility and also delta neutral. In this case you are long volatility regardless of the direction of the equity. $\endgroup$ – AlRacoon Feb 5 '18 at 17:23
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In regards to point 3, that is not entirely false. You can create a delta one position synthetically with options and have a predefined potential gain/loss profile. Having the ability to buy an asset on margin still carries the uncertainty of what is going to happen with respect to price. This is not the case with options as you can know what your payoff picture will look like before you even enter into the trade. This is one reason people will trade options speculatively.

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Claim 1 has merit on its own. For claims 2 and 3, I offer this: it’s not so much a question of whether these suppositions have any merit, but rather regarding people’s perception of their veracity.

To that end, there is a perception that options provide more favorable leverage than margin. Whether that’s true or not would have to be dealt on a case by case basis, but there's a strong bias in humans to overestimate their abilities to predict specific outcomes (e.g., $S_T > K$) over specific time horizons (e.g., $\forall \,t \in T $).

Moreover, the leverage aspect may be related to the volatility/beta phenomenon whereby investors who are not able to use margin and/or are capitally constrained instead seek to find leverage elsewhere (e.g., beta, options, etc...)

Also, there exist a common perception that options provide more favorable risk-reward profiles than outright positions in the underlying. But as you point out, for the no arbitrage principle to hold, no combinations of positions can have a greater expected return than the underlying. While An efficient market does not rule out the possibility that certain traders can have edge -- either with regard to directional outcomes or derivative outcomes -- in aggregate options are nearly a zero sum game, so the perception of greater rewards ties back into human bias which values flexibility in its own right.

So, I think the answer actually ties back to question regarding speculation, which has a connotation that perception often affects decisions more than reality itself.

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I would suggest you sample the free options courses (beginner, intermediate, and advanced given by Option Alpha (https://optionalpha.com/members/tracks). Membership is free and the course videos are enlightening even to the experienced trader. To summarize: 1) One of the main determinants of option prices is "implied volatility" of the underlying equity. This is the volatility determined by supply and demand for the underlying and is built into the option price as an estimate of future volatility. It differs from the "historical volatility" in that it generally inflates the option price. This works against the option buyer and works in favor of the option seller. 2) If you buy or sell the underlying, you are betting on a rise or fall in its price. If you trade options contracts, you can set up strategies that create both a profitable range and a fixed amount of potential loss. (3) There still is risk, but it is calculable risk and, by keeping your positions small, relative to your trading capital it is possible to manage the risk.

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