Sunday, July 13, 2008

Options Aren't Risky People Are Risky

Every time someone says something about option trading the majority of people automatically think, aren’t options risky? The answer to that is no, options aren’t risky people are risky. Options can give a trader a great advantage in the market if used correctly. If they are used incorrectly they can give you accelerated loss.

Let’s do some comparisons. There is a $40 stock that we would expect to go up in the short term. If we bought the stock and it went up we can make money. But if it goes down we can lose up to $40.

Now suppose we buy a $40 call for $5. Now we still have the ability to profit from this trade if it goes up, but now if the stock goes down we can only lose $5. I would rather risk $5 then $40 for the same trade.

This makes sense because it can limit your risk without limiting your upside. However many people still consider option trading riskier then stock trading. Perhaps the biggest reason for this is that most people trade options the wrong way.

Most people will make one of these mistakes when trading options

1. They buy an option based on long term prospective. Options are not built for the long term. If you like a company because you believe the stock will be worth a lot more in 10 years do not buy an option.

2. Some people try and hold onto an option if it turns against them. Most new traders will buy a stock and if it goes against them they will just hold it forever and hope it goes up and they break even. You cannot do this with options. They all have an expiration date and will expire worthless if you try and hold onto it forever waiting to break even.

3. They will not manage their risk. People like options because they give them a smaller loss if they are wrong but they end up buying more because options are cheap. Instead of buying 100 shares at $40 like they wanted they buy 1000 shares with calls for $5 each. Now they actually increased the risk they would have took by buying 10 times as many shares then they would if they just bought the stock.

4. Not developing a system. When you are buying stocks most people will blindly buy random mutual funds and ETFs and hope that 30 years later you will have made money. With options you need to develop that can tell you when to buy and when to sell in the short term. Most failed option traders don’t have this. They buy when they feel the company might go up not when their trading rules tell them it will.

What you should do to trade options correctly is

1. Develop a trading strategy that gives you entry and exit signals. Without consistency you will never be able to have any long term success in the markets.

2. Always use proper risk management when trading options. The general rule when trading is never to risk any more then 2-5% of your account in any 1 trade. This rule is especially important when trading with options. If you risk anymore then that you will be kicking yourself if you lose money on the trade.
Options are not for everyone, but can definitely be helpful when trading.

To learn more about options visit

To learn more about the stock market visit

1 comment:

Mark Wolfinger said...

Agree that options are risk-reducing investment tools, but it's not necessary to buy options. In fact, the odds of success favor the option seller.

I've been a professional options trader for mor than 30 years and I recommend six basic premium-selling strategies for the options rookie: