How to Trade Options
“How to trade options ?” and “What is Options Trading ” are two questions that I have recieved on this site and I thought I would try to answer it the best I can in this post.
Realize that these questions are quite broad but the best way to start is to summarize what exactly an option is. You can refer to my past post called Getting Started in Options Trading tounderstand the basics of options.
Options trading is a broad term for using options with your investment strategy whether you are:
Directional Options Trading
Directional trader will buy call options as a leveraged bet on upward move of a stock and buy puts as a leveraged bet on a stock moving down. This is the type of trading gets a bad rap because the typical small trader investor that tries options is doing it to speculate on stock price since options require less money than buying shares. The biggest mistake is buying a short term out of the money option.
Buying an short term option that is out of the money will have rapid premium erosion due to expiration coming up and is therefore leaving you little room to be profitable. You are essentially making a short term bet that the stock will move in the direction you desire before the option expires.
Income Options Trading
Income traders sell options to collect the premium from the sold options and generate premiums called “credits” in their account. Generally they would prefer for the stock to just not move so that they can just collect the time decay. This is by far my favorite thing about options is being able to collect income on options you sold even if the stock doesn’t move.
Selling option premium is like collecting a dividend but you can keep collecting it every week if you like(weekly options) or adjust the position if it goes against you. I think a lot of people are intimidated by options but if they knew more about them then I think you would see more investors writing calls on their long term investments to be able to generate income on their positions even if the market doesn’t move or stays in a flat range for YEARS.
Hedge Options Trading
Hedge trader is simply using options as a way to protect their investments against potential losses. Many investors use options to protect against big drops in a stock if eanrings are coming up or if they have a large position they want to protect.
Another way you can hedge a big position with options is to do what many CEO’s and people with large company stock positions by creating a “Collage Trade”. For example, if a person has a large amount of their net worth tied up in their company stock and wants to protect it from downside but can’t sell the stock because of insider sale restrictions or capital gains then they can do a collar trade.
Many independent investors have no idea what a collar trade is so here is a basic example of the steps involved:
- Own 1,000shares of XYZ stock that trades at $50
- Buy 10 put contracts with $50 strike price to guarantee that you can sell the stock at $50 if it drops.(You can buy a long term put so prevent time decay and allow long term protection). 1 option contract equates to 100 shares of stock.
- Sell 10 out of the money calls each week(weekly options) or each month(monthly options) with near term expiration to generate income on those call options to pay for your long term puts that you bought while generating consistent income on the position.
By implementing that collar trade the person is locking in price range for the stock so they are NOT exposed to catastrophic loss if the stock dropped. (Just think if your net worth as a long term company employee was invested in Enron, Worldcom, Washington Mutual Bank, AIG, General Motors…..and you watched it goto nothing. You get the picture.)
Realize that you can literally use options with any type of investment strategy whether you are are a long term investor or short term trader. For trading options, once you have the basics with how options work, how they are priced, factors that affect options pricing,etc… then you can start figuring out the type of options strategies that work for you and your investment goals.
The huge advantage of options over stocks is that you can set up a strategy that controls a max loss and gain and you can continue to adjust the position until it works out.
It is usually better to start slow with trading options by trading a small number of contracts and knowing what you risk/reward goals are before entering a trade.
Also, I find it better to start with controlled risk strategies like vertical spreads so that you get a feel for how time decay, volatility, etc. affect the options. Learn to look at a risk/reward graph and realize that options allow you to roll a losing position to a future month if you want to stay in the position and potentially recover from the initial loss.
Risks of Options
As mentioned above, options have a specific expiration date so if you buy an option that is “out of the money” then if will expire worthless and you would lose 100% of your investment. To prevent this risk you need to understand how an option is priced and do the proper strategies to have proper returns vs. risk. Options are an amazing tool to use with your investments and as the flexibility to trade options, hedge positions, or just make controlled bets can’t be replicated by other investment vehicles.
If you want to learn more about options courses I wrote a post about the popular ones. Here is Link to Post