Options Trading Isn’t As Complicated as You Think. Hand-Cranking Ice Cream is Way Harder.
In the last several weeks I have been pushing my family to try more and more new things and to break out of our typical daily rut. Gone are Taco Tuesdays, begrudgingly replaced by occasional ahi tuna or salmon. Constant soccer practices and games have been broken up with more golf and tennis lessons as we branch out to teach our kids new sports. And today I challenge those of you who have never learned about options and options trading to take the first step to learning about Call and Put options.
This past weekend I was at a neighborhood BBQ and the host brought out an old wood bucket and told the party guests that everyone was going to work together to make homemade ice cream using only eggs, ice, sugar and Half & Half. And to do this we would have to hand crank these ingredients for nearly hour.
Once considered a niche segment of the investing world, options trading has now gone mainstream. With little knowledge on the best strategies, you can use options to rig the odds in your favor and make trades that have up to an 80% probability of success. Find out how in this free report, How Options Work—and How to Hedge Portfolios with Options.
Once considered a niche segment of the investing world, options trading has now gone mainstream.
With little knowledge on the best strategies, you can use options to rig the odds in your favor and make trades that have up to an 80% probability of success. Find out how in this free report, How Options Work—and How to Hedge Portfolios with Options.Read Your Free Report Here.
Here is a picture of me taking a well-deserved break from struggling to crank the ice cream:
I had never heard of such a thing, and was mocked for never having participated in this tradition. (Am I alone in never having hand cranked ice cream?! Feel free to leave your experience, if you have had any, in the comments section below.)
And while the sweat was pouring off my forehead as I struggled with the hand crank for nearly 15 minutes, you should not sweat learning about options trading.
Too many investors think of options trading as gambling, or an exotic derivative that only Harvard and M.I.T. mathematicians can understand. That could not be farther from the truth. I truly believe that any investor who’s willing to commit to learning from an experienced trader will soon find that trading options is not gambling.
Some of the savviest, most seasoned investors are still clueless when it comes to options trading. Others know the basics of options, but are skeptical about the perceived risks that accompany it. Sadly, that skepticism is rooted in a fundamental misunderstanding of how options work.
That misunderstanding precipitates bad information, and that bad information has been repeated so often among options detractors that at a certain point, it became myth.
It’s time to identify those myths … and expose them.
Five Options Trading Myths
Myth 1: Options trading is too risky.
It is true that options are risky if you don’t know what you’re doing. But with a little education on the subject, options trading can be as safe as you want it to be. When done right, the whole point of options is to reduce risk.
Options are all about probabilities, which enable you to choose your level of risk in a trade. For example, if you want to play it safe and hit “singles”—i.e., go for modest returns that eventually add up if you string enough of them together—you can choose a trade that has an 80% probability of success. If you’re willing to take on more risk by going for home runs even if it increases the chance that you’ll swing and miss, you can reduce your probability of success in exchange for a much bigger payoff.
So really, the notion that options trading is risky is only part myth. Options trading can be risky … but only for the uninitiated. Which brings me to myth No. 2 …
Myth 2: Options trading is too confusing.
It’s true that trading options is more complex than buying and selling stocks. Options comes with its own vernacular—covered calls, selling puts, the strike price, iron condors, etc.—and that requires some getting used to, but it’s not like learning how to split the atom. Like most things, options can be learned easily if you’re willing to put in just a little bit of time.
Once learned, the options-trading process will quickly become second nature. You don’t have to be a seasoned professional to trade options. There are plenty of self-directed investors who picked it up and now trade options regularly. You can too.
Myth 3: You need a lot of money to trade options.
Not really. For most trades, you don’t need more than $1,000 in capital. And why is this? Because the most powerful factor of options is the leverage you get when buying calls and puts. For example, instead of paying $5,000 to buy 100 shares of stock XYZ, with options you can pay $200, and have the same upside potential as if you had bought the stock.
But whether you have $1,000 or $100,000, you should plan on allocating between 2% and 5% to each trade. By not risking too much on any one trade, and with the awesome potential of the leverage that options allows, you should theoretically get more mileage—and hopefully more profits—from your options money than you would if you invested that money in 10 stocks.
Myth 4: Options require a bull market.
Not necessarily. Through the magic of puts, you can still profit even when the market begins to fall. In traditional investing, the average investor can’t outright short the market by selling stocks or indexes short because of the unlimited upside risk. However, puts allow options traders to gain bearish exposure at a fraction of the cost. A put purchase is used when a decline in the price of the underlying stock or ETF is expected.
For example, if you expect stock XYZ to fall, you could buy a put at a specific strike price with unlimited potential for profits. The maximum loss on the trade is the amount of premium paid. For example, the purchase of the XYZ 100 put for $1 would only risk the $1 paid. If the stock were to close at $100 or above at expiration, the put would expire worthless, and your loss would be limited to the $1. However, if the stock were to go below $99, the holder of this put would make $100 per contract purchased per point below $99. By purchasing puts, you can take advantage of a down market with low-risk, high-reward trades.
Myth 5: You can only trade options on stocks you already own.
Wrong. The beauty of options trading is that you’re not limited to the stocks already in your portfolio. An option is a contract that conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day).
The advantage of trading options is that, unlike buying stocks, you can define your risk ahead of time.
When you buy an individual stock, you put a relatively large chunk of capital to work, which exposes you to the occasional bombshell, whether it’s a bad earnings report, a big drop in the market or a random company-specific event that brings out the sellers.
Options, on the other hand, give you the opportunity to get exposure with limited capital. If you know what you’re doing, you can make trades that have a 60%, 70% or even 80% probability of success. And options allow you to be more aggressive too—you can take on more risk to potentially earn a bigger return.
And your risks are clearly defined ahead of time in a way that’s impossible to duplicate through pure stock trading.
At Cabot Options Trader, I offer a complete options education, and only recommend trades in which the odds are clearly in our favor. When I buy options, I risk pennies to make dollars. When I sell options, I never expose my subscribers to any catastrophic risks. Sometimes I go for singles; other times, I try to hit home runs. My options trading strategies are varied enough to cater to all investors depending on their investment objectives, risk tolerance and available assets.
Jacob Mintz is a professional options trader and Chief Analyst of Cabot Options Trader. He uses calls, puts and covered calls to guide investors to quick profits while always controlling risk. Beginners and experts alike can gain from following Jacob’s advice.Learn More
*This post has been updated from an original version.