Monday, 1 February 2016


Options have been misunderstood by the majority of individual investors for as long as they existed. Options have been around for a long time (since biblical times when a clever person bought call options on as many olive presses as possible and reaped large profits when the harvest was huge and people had to come to him to gain access to the presses), but they have been traded on an exchange only since 1973 (when the CBOE opened its doors).
Despite the fears of uneducated investors, these two statements are true: 
·         Options are risk-reducing investment tools.
·         Many option traders adopt very risky strategies using options, despite the fact that far more conservative strategies are available.

1.       DON'T BE GREEDY.
Be willing to own positions where profit potential is limited, rather than unlimited. 
Adopt strategies where losses are capped -- preventing a financial disaster -- and with a high probability of success.
Bullish traders can sell out-of-the-money put spreads.
Bearish traders can sell out-of-the-money call spreads.
In either scenario, do not sell spreads with a tiny premium.

Selling naked options places the seller at risk of a large loss. Remember that markets do unexpected things every so often, and it is important to practice sound risk management by avoiding owning positions that could -- no matter how unlikely -- blow up your account.
Note: It is acceptable to sell naked put options if two conditions are met: (a) You want to own shares of the underlying stock, even if the price plunges below the strike price; (b) you have enough cash in your account to buy those shares, if you are assigned an exercise notice on those puts.

2.      Understand that using options as mini-lottery tickets is a money-losing proposition. It is understandable that you want to dream big dreams. However, when placing your money at risk (every trade comes with some risk), it is important for traders to consider the probability of earning a profit, and not only the size of that potential profit. 
Do not make a habit of buying inexpensive, low-Delta, out-of-the-money options. Sure it is tempting to buy an option for $10 or $20 when there is a chance of scoring a 10-bagger (i.e., earning 10 times the cost of the option), but those options have very little chance of performing as you hope. 
You may believe that the price of a specific stock has a good chance rise from $44 to $57 over the next couple of months, but that is a very unrealistic expectation (unless you have inside information -- in which case it is against the law to buy options). Buying calls with a $55 strike price options is just foolish because such options tend to expire worthless. Sure the loss is small, but the chances of earning money with this strategy are even smaller.

3.      Use options to reduce the risk associated with owning stock. If you own stock, as most investors do, you can use option strategies to reduce your loss if the stock price declines.
One strategy (covered call writing) provides only a small amount of protection, but over the long-term has been shown to outperform the buy-and-hold stock strategy. This strategy comes with a limited potential profit, and is suitable for investors who seek steady, long term growth, rather than those who want to find stocks whose price can double very quickly. The attractiveness of this method is that it increases the chances of earning a profit when compared with simple buy and hold. 
Another strategy costs money and makes it more difficult to earn any profit -- unless the stock market is strong. However, this method is attractive to conservative investors because it affords complete protection against a disaster when the stock price tumbles. This strategy involves the purchase of put options (protective puts) when you already own stock.

      There are additional strategies that allow stock market investors to participate in both bullish and bearish markets with limited risk, but if you understand the basics of how and why the ideas above work, then you will be well placed to continue your options education and learn other investing methods.

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