Most people say option trading is risky.
Novice traders often don’t take the time to learn the right way to use options. They jump right in – thinking, “I got this.”
They gamble, blow up their accounts, and walk away penniless and swearing off options forever.
Even experienced traders sometimes get caught up in the allure of fast gains. They overleverage their positions – taking a bigger position size than they should – and then take a hit. All the option traders I know, including myself, have blown up their accounts at least once.
But, it’s not the option that’s risky… it’s the strategy. And when using the correct strategy, options are far less risky than trading stocks.
You see, most people use options the wrong way. Most people use options to increase leverage… to get more “bang for their buck.” In other words, most people use options to increase risk.
That’s wrong. That’s the exact opposite of what options were designed for.
The options market was created so investors could reduce risk. Options allow investors to hedge their positions… and to risk much less money than they would buying a stock outright.
Let’s say you want to buy stock in Company X. It trades for $10 a share. You could put up $1,000 to buy 100 shares… But you can control the same amount of stock with one option contract. You can buy a contract for, let’s say, $50… and leave the other $950 in your account.
If Company X’s stock goes up, you’ll make money. If the stock goes down, the most you’ll ever lose is that $50. That’s a 100% loss… but it’s a lot less than potentially losing 20% or more of the $1,000 you risked buying the stock.
This is a simple example. And, it’s the simplicity that proves my point. Options allow you to risk much less, yet profit just as much as buying stocks.
But, that benefit disappears if you overleverage the trade and take on a larger position with options than you would otherwise take with the stock.
That’s the biggest mistake most novice option traders make. Instead of replacing a 100-share purchase with one call option, they take the entire amount they would’ve allocated to the stock and buy a much larger position with the options.
Rather than buying one call option for $50 and leaving the remaining $950 in the bank, novice traders take the entire $1,000 and put it into buying more call options.
They end up buying 20 call options to try to get more bang for their buck. What would’ve been a 100-share purchase has turned into control of 2,000 shares. Instead of using options to reduce risk, they’ve increased their risk by 20 times.
Losing 100% on an overleveraged trade would be a disaster. And, it’s why most folks think option trading is dangerous. But, it’s not dangerous if you trade options the way they were originally intended… as a way to reduce risk.
Limit your option exposure to control just the number of shares you would normally purchase. Leave the rest of the money in the bank. Then, it won’t be so bad losing 100% on an option trade.
It will almost always turn out better than what you could’ve lost on the stock.
Best regards and good trading,
Editor, Market Minute