Options Trading Tips

Options trading is not for beginners. While derivatives are not in and of themselves bad for investors per se, they do require the investor to understand where the value of those derivatives comes from, and most investors will not be willing to put in the effort to fully understand when and where options trading will make sense. If you’re just getting started out in investing, please check out a quality book like The Boglehead’s Guide To Investing or All About Asset Allocation, paying close attention to the material on index mutual funds. Your time will be better spent there.  For experience investors wanting a peak at the world of trading stock options, the following options trading tips may be of interest.

Remember, Options Are Derivatives

For those of you that remain, be aware that while options trading allow you to potentially magnify gains in any transaction, they can also magnify losses just as well. Options aren’t terribly difficult to understand, but it is easy to make a mistake when dealing with any derivative, so you need to make sure you know what you’re doing before buying or selling any call or put options. Because stock options are a tradable commodity on their own, few options actually expire and sell for the strike price. This means it is very easy to get blinded to the fact that you are trading in a derivative, and it is important to keep fully in mind what the actual value of the derivative truly is.

Never Be In The Short Position

Whether you’re certain a stock will rise or fall, you should always purchase either a buy or put option. Never sell an option. Selling options amounts to nothing more than playing with fire. When you buy a call or put option, you are buying the right to purchase or sell stock at the strike price, allowing you to potentially make a lot of money if the stock moves as you predict, and take a capped loss if it doesn’t. You will always know how much you stand to lose when you buy an option. Sellers of options are in the opposite position—a short call writer can only earn a predetermined amount of money, even if they predict the market perfectly. But if the short call writer screws up, there is no limit to the amount of loss they’ll be liable for.

Always Be In The Short Position

Like all good stock advice, there’s another side to every situation. It’s difficult to really make money in the long position. When you buy a call or put option, you are basically purchasing insurance that the stock won’t do the opposite of what you predict; if it ends up doing so, you are covered on your losses. The drawback, of course, is that your gains are significantly less due to the inherent value of this “insurance” you are buying when you are in the long position. When you sell a call or put option, you are doing so without any “insurance”, and thus stand to make money more often than whomever ends up buying your options. Yes, your gains are capped, but if you’re reasonably certain that a stock will maintain its price, a short put option is an easy way to make some extra income on the side. If the stock drops precipitously, you’ll be in big trouble. If it rises significantly, you’ll also miss out on potential profits. But so long as it stays about the same, you’ll make some good money on a stock that otherwise isn’t doing very much. Since most large companies have stocks that tend to hover around the same price, a short call is usually a fairly good bet to make.

Don’t Deal In Derivatives

Finally, this article would be negligent in its duties if it didn’t remind the reader that derivative trading takes a good deal of concentration for gains that would probably be more easily achieved with a simple index fund investment. Some traders do very well with derivative trading, but not more than would be expected by chance alone. Unless you just intrinsically enjoy the fun of trading stock options, remember that index funds will, on average, earn you about the same amount for far less effort.