Is Option Trading Really That Complicated?
Dec 16th, 2009 by Carlos
Short answer: yes, there is a lot to learn when it comes to options.
Long answer: it’s not as hard as you think. Most people assume that options are too complicated for their little minds to grasp, so they don’t even try to. And the little bit they do they know is usually wrong.
Options are actually less risky that stocks. That’s right—I said it. But am I full of crap? I mean, so many more people trade stocks than options—why would novice investors use a tool that’s riskier than the less popular one?
Ignorance. People just don’t know.
My Experience with Options
I made my very first options trade last week, and I’m damn proud of it. I studied options for months (the book, Understanding Options, was invaluable—do check it out if you want to learn this stuff), traded them virtually, and asked people that knew much more than me to show me the ropes.
All that culminated in my first real trade last week, and now I can share some of what I’ve learned along the way to dispel the myths that are commonly associated with options.
Myth #1: They are too Risky
False: options allow you to make trades that eliminate a lot of the risk you face with stocks.
The way options work, you can cap your losses (and your wins) so you know exactly how much you’ll lose if the worst-case scenario happens. A stock can go all the way to zero and you lose all your investment. Options allow you to say “I am willing to cap my gains at X, but I also want to cap my losses at Y.”
Sure, you can set stop losses when trading stocks, but most people don’t do that because they don’t know when to sell. The allure of a stock bouncing back and shooting up is usually too high. With options, time is built in: expiration dates force you out (or in) of a position—no more worrying about when the “perfect” time to sell is.
Myth #2: I Need a LOT of Money
False: You don’t.
Sure, if you want to make a ton of money, you’ll have to have a lot in your account to execute some of the fancier positions out there. But because options allow you leverage very effectively, you can make more money that you could with that same amount of money in stocks.
Since one option contract represents 100 shares, minute gains turn to real nice ones pretty quickly…if you play your cards right.
Myth #3: They are Too Complicated for Me
Depends: How much do you want to learn it?
If stocks are like checkers, then options are like playing chess. You’re playing on the same board (the world of stocks) with different pieces (options vs. stocks) and with different rules.
But checkers is for kids and it’s kind of boring. If you can move up from checkers to chess, you can go from stocks to options.
There’s a good reason to make the move: options allow you to do make moves that are much more interesting. With stocks, you’re trading idea is that it will go up or down. You can buy a stock or sell it short.
Boooo-riiiinngggg.
With options, the choices are unlimited. Here are some of the things you can express with options:
- This company rocks, I want it to go up! But I don’t want to lose more than X.
- This company sucks, but in case it goes up, I want to be protected.
- This company is OK, but I think it’s going to stay below $40 for the next three months.
- I think this company is going up, but I don’t want to pay it’s current price to own the stock. So until it hits this lower price, I just want to take in some premium ($).
- I think this company is great, but I’m not positive it will go up. I think it will stay above X for the next month, and if it does I want to make money.
This is a smattering of the strategies you can put into place with options. Isn’t it more intellectually stimulating than “up or down”?
Interested?
I’m not sure if my readers (that’s you!) even care about options. So if you don’t, please let me know! But my short time with them have been a very good learning experience, and I’d love to share more of it with you.
They aren’t for everyone, but I like using them as a vehicle to express my short-term views on the market. For the long term, I’m covered with index funds.
And don’t forget about the comments section—you know I love me some comments!
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Image by Perpetualtourist2000
This post was included in the Money Hacks Carnival
Thank you for confirming to people what I’ve been saying for years. There seems to be this need among options traders to make it more complicated than it needs to be and thus make themselves seem more intelligent and sophisticated the anyone else. For the most part I’ve stopped making stock trades in the shares themselves anymore. Using options suits the timeframe and types of trades I prefer to do quite nicely.
John: In defense of all the folks out there that are intimidated by options, I understand. It took me a while to understand how they work and how much simpler they are then they seem at first.
Maybe I’ll write something up that introduces options in as simple a fashion as I can. I’ll try to do my part to get the word out. It won’t be for everyone, but a lot of people should at least try them out.
I’d love to read how to decide on choosing a price/timeframe for selling covered options, and what you have to do to prepare for the possiblity of covering those options.
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