Many people think that options trading is a very risky investment. Although there are risks involved in options trading, there are also risks in stock trading, mutual fund trading, and almost any other investment in the world. What I found is that if you use defined risk strategies, you can minimize your risk even lower than stock trading.
If you were to buy a $50 stock, your risk on one share this $50 to the downside. Assuming along that stock, everything to the upside is profitable. With options, you can simulate a long stock trade for much less than the $50 investment. Because your investment is lower, any return on capital would be bigger than the long stock purchase.
In fact, I believe there are a few trades that are almost risk-free. The risk on a naked put on an ETF where you’re willing to roll as long as it takes for your put to be out of the money again would be lower risk than waiting for a stock that’s dropped from $50 to $40 to come back to $50. You also generally have more flexibility with options, and that you could let yourself be assigned the put then sell covered calls at the price of the strike that you had your naked put at until that stocks it called away from you. I’ve done this on $10-$12 stocks and made much more than any index could offer you. The risk is zero from a loss standpoint. The risk is in the loss of a return on your capital. Given this as an option, if you were really worried about losing money, this would be a much safer trade than any long stock.
This is just an example to attempt to sway the option naysayers into believing that options can be a better, more flexible trading instrument. This hasn’t always been the case, but now with electronic trading and some other benefits, option should at least play a part in your trading strategy.
Here are some of the reasons why options trading is the new black:
- Penny wide markets: many liquid stocks traded penny wide increments. Long gone are the days of fractional trading. Even if an option you are trading as a wider bid and ask than one penny wide, you can often trade in between the bid and the ask and very likely you could be filled.
- One dollar wide strike prices: many liquid stocks today are traded with one dollar wide strike prices, at least in the near month options. This gives you a lot of flexibility in reducing your margin requirements and maximizing return on capital. You could invest in a very expensive stock like Google ($GOOG), Apple ($AAPL) or Bidu ($bidu) and risk only one dollar make a return on your investment. Even if you have a more expensive stock with five dollar wide strikes, your risk is only what you set out to gain minus 5 dollars.
- Higher return on capital (ROC): if you were to buy a stock at $50 and it worked go up five dollars, you would have a 10% return on capital. However, if you were to make a trade using an option spread that only cost you three dollars put on but went up four dollars, your return on capital would be over 100%. For the same to happen put a stock trader your $50 stock would have to rise $120.
- Higher probability of profit (POP): a higher return on capital will naturally improve your probability of profit. Knowing what type of trade to put on at what time is the key to improving your probability of profit. Selling options in high volatility environments, or with high volatility underlying stocks will also improve the probability of profit.
Probably the biggest investment when you commit to trading options is not the cost involved, but the education be effective. When I got into trading options in 2004, there was little choice but to pay someone to teach you. Although you could find information on the Internet, most of it cannot be trusted. What I found is there are better, free resources than ever before. Starting with SellTheta.com where you can post questions, interact on our forums, and monitor our trades. We also recommend several other websites in our forum under the category “tools and resources for stock and options traders”. You can visit that area of our forum by clicking here.
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