So you’re ready to set out on a profitable and enjoyable options trading career. While we applaud your enthusiasm, options cannot be rushed into without at least knowing the basics. One of the gifts of options investing is the versatility it affords investors. There are ways to profit from bullish and bearish moves, of course, but there are also strategies that can help you earn a few bucks in choppy, sideways markets. In addition, you can start an options trade in one direction and add legs to it to switch directions and enhance your time horizon to bolster your chances for a winning trade.
The other side of this coin is that while the versatility that options offer is a great thing, it can also be confusing to investors new to the options game. Options strategies abound with funny names like collars, strangles, spreads and straddles that are not for new investors. That doesn’t mean you can’t make some nice profits trading options. It just means options rookies need to refine their system before getting into the game.
Know The Basics
In an effort to keep things simple, new options investors should focus on equity options. These are options where the underlying security is a common stock. There are options available for myriad products and these are worth including in your portfolio, but only after you’ve mastered the basics of equity options. Remember that when you see the price for an option that price is for each share in the contract and an equity options contract grants you control of 100 shares. So if you see an options quoted at $2, it will cost you $200 to buy one contract ($2 x 100 = $200).
Next, let’s look at the basics of beginning options strategies. As rookie options traders, it’s probably best to stick with buying puts and calls. We buy puts when we’re feeling bearish about a stock. As put buyers, we’re “long” on the puts because the puts increase in value as the underlying stock decreases. Buying puts is a great alternative to directly shorting stocks because our risk is limited to the premium paid for the contract. When we directly short stock our risk is unlimited because, in theory, the stock could rise to infinity, destroying our account in the process.
The next beginner options strategy is buying calls, which we do when we’re feeling bullish about the underlying stock. Again, our risk is limited to the premium paid for the contract and that keeps our risk profile low. Another advantage of calls is that if we pick the right ones, they pack great profit potential and can often return greater percentages than the underlying stock even as the stock rises itself.
Finding The Best Options
While we would never enter into any investment vehicle without knowing the chances for success, this is especially true with options. See the rub with options is we can’t hold them forever. We can’t even hold them for three or four years like we can with stocks or bonds. Options are impacted by time decay. Options contracts expire on the third Friday of every month and as our contracts get closer to expiration, time decay becomes more of an issue.
Look at it this way. Let’s say you buy some August 50 calls in Coke when the stock is trading at $49. You need Coke stock to be above $50 on expiration date to make money on this trade. The other problem with time decay is that as expiration date draws near and your option is sitting out-of-the-money more traders start to take positions in the opposing contracts that are in-the-money, making it harder for you to make money.
To counter this problem and put the probabilities on your side, you have to study statistical and implied volatility. Both of these can help options investors calculate their risk and understand their desired options’ chances for success. Beginning options traders need to understand time decay in order to be successful.
One More Step For The Rookies
It may seem like a good idea to take on more risk by purchasing puts or calls that are out-of-the-money, meaning a call’s strike price is below the current market price and a put’s strike price is above where the stock is trading at. The premiums for out-of-the-money options are cheaper for a reason: Because they are riskier. Yes, there is more profit potential, so consider buying out-of-the-money options as a step you graduate to after becoming proficient with in-the-money purchases.