For the small speculator venturing into stock market trading, a possible attractive avenue of promising financial returns is in trading options. But before mentioning the advantages, let us address the most frequently cited negative aspects of trading options.
A poor success rate when using flawed strategies
Most option traders lose money, even those, it seems, with experience in trading in stocks and who are knowledgeable professionals working in the stock market. The figure often quoted is that 90 percent lose money with options, that’s a terrible record. But professionals know it and admit to the fact.
A major reason that losses occur is that trader’s are attracted to the cheap options that are out of the money with a near term expiry. Cheap to buy, yes, but far too risky and only occasionally likely to provide a winning trade. Follow the link at the end of this trade to Four Rules for Trading Options.
Many investors believe that trading options is akin to gambling in Las Vegas – and at the high-risk tables. I’m not sure if they have high-risk tables, I’ve never been to Las Vegas and don’t gamble, unless it really is gambling to trade options.
Not everyone fails
On the flip side, many full-time traders do very well with options and trade them on a frequent basis. One very experience trader I know of and whom I do believe is successful, claims he has only traded in options for many years, never in stocks.
My favorite pundit on investing and trading for the beginner, William J. O’Neil, founder of the Investor’s Business Daily and author of many best selling books on investment, has written on the matter with a cautionary comment. His opinion is that once a person has shown they know how to make money in common stocks and understands the market, only then “ the limited use of options might be intelligently considered.”
Options can provide a big bang for a buck if used properly. Options are also widely used for hedging by sophisticated professionals with a high degree of success and profit, in fact their original use, dating back hundreds of years, was primarily to provide a hedge, a form of insurance in many transactions involving a variety of equities. But that form of use is not what we are considering here.
Start with simple call and put options
But the beginner, if deciding to trade in options, could start with the simplest and easiest form of option play, to buy either call options or put options.
The usual definitions for an American style of stock options are:
A call is a contract that conveys the right, although not the obligation, to buy a specified stock at a specified price within a specified time, after which the option no longer exists.
A put is a contract that conveys the right, although not the obligation, to sell a specified stock at a specified price within a specified time, after which the option no longer exists.
A contract controls 100 shares of the underlying stock and the option price is indicated per one share, the actual cost of the contract being 100 times the individual one share option price.
The above reference to American style is made because there are other less common options styles such as European style options that have different rules.
To be successful in trading options the trader must be able to pick stocks that can reasonably be expected to perform as forecast within the given time before expiration, either rising in price or falling in price, depending on whether a call or put.
Choose the stock, set the option strike price and the term
When buying one or more option contracts on a specified stock, two other conditions must be specified, the “strike price”, that is the price at which the option can be executed and the “term” that specifies the date at which the option expires.
The strike price can be a price above the current market price of the stock, below that price, or the same price. In stock market terminology those are referred to as “out of the money, in the money, or at the money” respectively.
For a call, the more a strike price is priced In the Money, meaning priced at a lower strike price than the current market price, the more expensive the option will be compared with a strike price that is At the Money or Out of the Money.
Term, Expiration Date
The term specified indicates when the option expires. There are usually several dates of expiry available for various months in the future that conform to pre-set calendar dates and their option prices will vary accordingly.
The closer the expiration date is set to the current trading date the lower the price of the option should be and the higher would be the risk because of the shorter time to realize the required change in value of the underlying stock.
Leverage is the great advantage
It is the leverage provided in trading options that is the great benefit. A comparatively small amount of money can allow participation in the trading activity of much higher priced stocks. The smaller financial stake allows the smaller retail investor to trade options in cases where the higher investment required for high priced stocks may tie up too much working capital for comfort.
There is higher risk involved in trading options but the potential returns on a successful option trade should be many times the amount in percentage terms that would be gained in a straight stock purchase.
It is an odd consolation but the most that can be lost in an options purchase is the total amount paid for the options, with some exceptions that the beginner should not be involved with. So that amount at risk with a call or put option is fixed. And the option can be sold before the expiration date to reduce a potential loss if there is sufficient time left until expiration and if there is any positive intrinsic value, the difference between the strike price and the underlying stock price. The option is usually worth at about what the option holder would receive if the option were executed.
To repeat, success depends on the ability to pick stocks that perform to expectations within the specified term. It sounds simple and it doesn’t always happen but when it does, it is very rewarding. Definitely worth reading up on to learn the strategies to adopt that give the best chance of success and at the same time minimize the risks involved.