Wednesday, April 16, 2008

Should you use options when trading?

Options are very powerful investment vehicles. They offer a way to get higher leverage from your money in the stock market. To understand if you should use options you should first understand what options are.

When you buy an option what you are actually doing is buying the right to do something. Either buy a stock at a given price or sell it at a given price. There are 2 different types of options.

1. Call options give the owner the right to buy a given stock at a given price by a certain date. For example if you buy a January $80 call on stock XYZ you would have the right to buy the stock at $80 by January no matter what price the stock would be at.

2. Put options are the exact opposite of that. They give the buyer the right to sell a stock at a certain price by a given day. An example of this would be if you buy a January $80 put option on XYZ you would have the right to sell it at $80 by January.

The benefits of options are that they offer a way to make huge returns on your money. If you buy a stock that goes from $100 to $120 you would make 20% off of that trade. However if you bought the $100 call for maybe $5 you would have made at least $15 or 300% off of that trade.

The flip side of that is that you also encounter large risk when you deal with options. If that same stock went to $90 you would have had a 10% loss in your stock and a 100% loss in your option. That would have given you a loss that most people could not stomach.

The large risk of loss in options is why you should use proper risk management when trading with them. Never risk more than 2% on any 1 trade. That way even if you suffer a 100% loss in your position it is only a 2% loss in your portfolio.

Also if you are a strict option trader you should never trade with your entire account at once. You may have many option orders open at once but the majority of your account should be in safer investment or in cash.

These rules may limit the potential profit an option could make you but they also limit your loss. If you don’t limit your loses with options chances are your account will suffer. Options can be beneficial to you but only you can say if you can take the high risk high reward scenario options offer.

To learn more about options visit http://www.stocks-simplified.com/options.html

To learn more about trading the stock market visit http://www.stocks-simplified.com

1 comment:

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