Option trading is widely misunderstood. Options can be pretty complicated, but they don’t have to be.
Yes, option trading can be risky, and yes you can make or lose significant amounts of money in the options market. Because these things are true, options have an aura about them which can confuse investors who do not fully understand their potential.
While it is true that options have inherent risks, it is also true that if done properly, options can actually be used to lower your risk while boosting your returns.
Because of the risk associated with options, a lot of investors falsely assume that only sophisticated investors with a wide range of investment tools are able to learn and master the art of option trading. This is not the case.
The truth is that successfully using options in your portfolio isn’t all that hard or complicated. You do not need a lot of fancy computer programs or unlimited capital in order to get into the game.
The first step in adding articles to your investment arsenal is to forget the things you think you know about options and learn the truth.
1. Options are always high risk
This is simply not the case. Yes, there are some strategies that are riskier than others, but there are many ways to play options. You can trade options with hedged strategies that are able to generate positive returns regardless of whether or not the stock rises, stays flat, or even drops by a few percentage points. When you buy stocks, the only way to win is if the stock moves higher… this is not the case with options. An example of one such strategy is the bull-put credit spread.
Let’s look at Apple (AAPL). Apple is currently trading around $530. A nice hedged trade would be the January 455/460 bull-put credit spread. You would sell the January 460 put, while buying the same number of January 455 puts, for a credit of 40 cents. This trade has a target return of 8.7%, with 11.4% downside protection. This means that as long as AAPL does not close under $460 on 1/18/14, you will realize an 8.7% profit on the trade. In other words, you can get an 8.7% return even if the stock drops by 11.4%. In order to get the same return with a stock only trade, the stock would have to rise to $565.
This is one case where the added downside protection can actually help you reduce your trading risk.
2. You need a lot of money to invest in options
Having a lot of money helps with any type of investment you are making, but it is certainly not a requirement when talking about options trading. You can trade options for a very low amount of money, by simply by trading a contract or two at a time and eventually working your way up as you get more comfortable with the process.
If you are simply buying calls or puts, you can get into trades for as little as $50 (although this may not be the best approach since trading commissions will eat you up at this level), but the point is that you really do not need to have a lot of cash to get started.
In our section on reducing risk we looked at a hedged trade, so let’s look at another hedged example and show how little money you would need.
In this example we are going to look at a Microsoft (MSFT). This stock has been strong this year, and you want to get in. You can set up a January 31/33 bull-put credit spread for a credit of 15 cents. This means you will sell the January 33 put while buying the same number of January 31 puts. Let’s say you decide to do 5 contracts. That means you will get a credit into your account of $75. (5 contracts x $0.15 x 100). This is your profit. As long as MSFT does not close below $33 on expiration you keep the $75. If the trade goes bad, your total risk is $1,000 – $75 = $925. So you are targeting an 8.1% return, with 11.8% downside protection, and your total at risk money is $925. You can ratchet up the number of contracts to boost your return, which will of course boost your risk, but you can find your own comfort level.
3. Option trading is all or nothing
I hear this one a lot. The perception of options as high-risk has many people believing that options are a lot like rolling dice. You are either going to hit, or you will crap out. This is simply not the case. Even in the highest-risk type of option trading you almost always have a way out. Granted, if you go naked on a call or put, and the next morning there is a huge gap up or down in the stock, then yes you could lose everything. But in all likelihood, this is not how things play out. Barring any sort of huge gap open on a stock, you can back out of almost any option trade. Are you going to take a hit? Yes. But you are not going to lose it all.
Even with hedged trades you can unwind your positions and get out, or better yet, rework the trade to expiration further out in the future and give the stock even longer to behave as you predict.
The truth is, that with options, you can realize quick profit and losses. The swings can be big, but you are almost always able to unwind trades and get some of your money back.
Say for example you are bullish on Wal-Mart (WMT). The stock is currently trading at $80.45. You believe that the stock is going higher, and want to buy a call on the stock in anticipation of future stock gains. You could buy the February $82.50 call for $1.00 a contract. With the stock trading just near its 52-week high, it would not be surprising for a little sell off on the horizon, and when it does your call option would lose value. But even if the stock does drop, your call will not fall to zero unless there is a sizable move. If you lose faith in the trade, you will have the option to sell your call on the open market to recoup some of your cost.
4. Options only work when volatility is high
A very common misconception is that volatility needs to be high in order for options to be profitable. The logic here is that in order for options trades to make money, the underlying security has to move wildly one direction or the other. This is simply not the case.
Does it help when volatility is high? Sure, a volatile stock tends to endure bigger swings, so the upside is much greater when you buy calls and puts on a highly volatile stock, but you really do not need a lot of volatility when making options trades, especially spread trades.
Let’s take a look at a stock with low volatility, Bed Bath & Beyond (BBBY). As you can see in the chart below, the stock has been in a fairly tight sideways pattern since July, and has little volatility. This is not something to discourage us from setting up a trade, and in fact can be used to our advantage.
BBBY is currently trading at $77.80. We could set up a February 67.50/70 bull-put credit spread on BBBY with a credit of 30 cents. The trade has a target return of 13.6%, which will be good as long as the stock does not drop 9.6%. We are using low volatility to our advantage because there is a reasonable chance that the stock will not run into a 9.6% sell off.
If the stock had more volatility, then we would have been able to ratchet up our credit and set up the trade with a higher target return, but we are still earning a nice 13.6% in a low volatile stock.
5. Options are hard to understand
A final reason a lot of investors never expand their investment approach to include options trading is the mistake of thinking they are too complicated for average investors to understand. A lot of people picture option traders sitting behind super computers running complex trading algorithms all day long to spot winning trades. While I concede that this exact scenario is playing itself somewhere around the world, I have never met any of these people, but I have met hundreds of investors, no different than me or you, that have been able to learn how to trade options successfully.
Options are not all that difficult to learn. The tricky part is that there are so many different ways to trade options. With stock only trades, it is easy… you buy or you sell, and hopefully you are able to sell for higher than you buy. The only tricky part is timing. With options you have to go a step further and decide which options strategy to use (hint: there are a lot!).
This is where people get confused. They hear phrases like condor, debit spread, strangle, and instantly start feeling overwhelmed and shift their attention. These strategies are not very difficult, you just have to spend a little time reading up on them and running a few test trades (I recommend some fake paper trades while starting out) to figure out how they work.
There are a lot of resources online, and plenty of training sites that you can use to learn the various strategies. It may seem like a lot at first, but you will quickly see how they all relate to one another, and how easy it can be to add options to your investing arsenal.