5 “Facts” Smart People Get Wrong About Options
Using options contracts to boost returns and income could be the most powerful investing tool that you’re not using. While trading options for the first time might be intimidating, we’ve broken it down to its core pieces and show that options aren’t as dangerous as you might think.
1) Options Trading is complicated
Markets can only do three things… go up, go down, or go sideways.
21 basic options strategies exist but knowing just over a handful will cover most market conditions and opportunities.
Simple options can profit from where a market goes or even where it doesn’t. Buying basic puts and calls is often where investors start as a lower cost stock substitution for buying or selling shares. The capital outlay is much less than paying for the stock or even buying on margin.
A basic stock substitution strategy, purchasing an option instead of longing or shorting shares, requires less capital outlay but has a greater potential return. Directional option plays profit if the stock moves in your desired direction and can multiply performance on even just a modest move.
Covered call writing against a long stock portfolio position can generate regular monthly income to lower the original share cost basis. The only downside of the additional cash flow is that profits are capped if the stock takes off.
2) Options are like gambling
A key benefit of using options is controlling probability. A stock investment has a 50/50 chance of rising or falling compared to option odds that can be chosen to put probability more in your favor.
Buying cheap out of the money options with little time until expiration, “lottery tickets”, often have little chance of making money.
The option Delta is a good approximation of the option chance of being in the money at expiration. Instead of hoping on long shots to come in, choose the option probability of success that fits your risk profile and trading personality.
With proper allocation and good money management, an investor only needs to be right 55-60% of the time to make money. A simple technique of choosing that high Delta can help you select option trades that have a 70% or higher probability of success and put the odds solidly on your side. I tend to prefer options trades that have a 70% or higher probability of being correct.
3) Time is the enemy
Option buyers can purchase extra time just in case they need it. If you think a market move is going to happen in a month, buy three months of time for safety, or a year if six months is the window of opportunity.
Too often, investors hold on hoping for something to happen right before option expiration. Take time out of the equation by buying more than you need; it is a valuable asset when you can wait until you are right.
A good rule of thumb is to exit early, as the feared time decay accelerates in the last 30 days prior to option expiration, so some get out of the long plays when the calendar turns to that expiration month.
Selling strategies can also take advantage of the passage time. Potentially, you can profit with options from where the market doesn’t go, therefore utilizing that time decay.
4) Options are risky
Options buyers have absolutely limited risk with the maximum loss being the premium paid, so risk control is built in. A money management stop loss can also be placed on an option to protect premium and lessen dollar exposure.
This money management technique works to salvage some of the initial investment when a position moves against you. Mathematically, if an option loses half of its value, either the stock has moved in the opposite desired direction or time for development is running out.
The worst thing that can happen is a long option going to zero. That is the maximum loss no matter what happens in the stock. Options are no different than other investment vehicles in the fact that the disciplined trading plan and focus on risk control separates successful traders from novice investors.
5) Options are short-term and only for active investors
Options are vehicles to fit most lifestyles and often don’t require daily attention. Options can also be used effectively for long term positioning with six months to a year or more until expiration. The combination of limited risk and staying power to ride market ups and downs makes options good for long range positioning without constant trade management.
A buy and hold approach using long options instead of stock can position for development over many weeks and months, or even years.
The leverage advantage of options can significantly increase performance returns. A modest 5-10% move in the underlying stock can produce impressive 50% or more return results with options. This multiplier effect on less investment cost makes your money work harder for you.
To see the power of options in action check out my October 11th trade recommendation, “A Gold Mine Options Trade” that produced at 50% return in just three weeks. Click here to see the article.
Though it had more than three months to profit, an outstanding return was produced in short order on a 10% jump in GDX the Gold Miners exchange traded fund.
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Note: The author of this article is Alan Knuckman.
Category: Options Trading
