For every great trade, there’s the “one that got away” — and probably more than one. Even professional traders take enough hard knocks to earn themselves a concussion, so to help you prevent cranial injury, let’s talk about how much money you should be allocating to your options trades.
Sometimes options can be priced just right … other times, they can seem cheap. Yet, in other situations, they can be trading at a steep premium. When market volatility (which is a measure of the fluctuation in the market price of the underlying security) is touching its highs, beware the trap of paying too much for overpriced options.
WHY DO OPTION PRICES CHANGE SO MUCH?
When volatility spikes, option premiums climb right alongside it. But then when we see a pullback in volatility, it’s similar to buying an item at full price and seeing it go on sale a week later. It just takes a little adjustment to volatility to whack down the option’s price (even when the underlying stock doesn’t move all that much).
The lesson here is to not invest too much money into one trade. Options, by their very nature, are short-term investments that allow you to control a lot of stock (100 shares per options contract) at a small price. These calculated tools can provide immense leverage, but leverage can work both ways! Make sure to never risk more in an option trade than you would be OK with losing completely.
Some investors get carried away with options, amazed at how inexpensive they are versus outright owning the underlying stock. Although options can cost anywhere from a few cents to more than your average stock price, depending on how high the shares are trading, I like to place my bets on options that are trading in the $1 (or, $100 per contract) range. That way, if they go up to $4, then I’ve just made a 300% return on my investment. But if the trade doesn’t go in my favor, the most I can lose on the trade is the $1 that I originally risked.
BUY HIGHER-QUALITY TRADES FOR THE SAME PRICE AS (OR LESS THAN) THE LONG SHOTS
A way to play higher-priced options yet still only pay a nominal amount to enter the trade is through a bull-call spread, which involves the purchasing of an at-the-money or in-the-money call option and then writing (i.e., selling to open) an out-of-the-money call option at a higher strike price.
And if you’re a little nervous about holding options short in your trading account, don’t worry — you’re covered by those long calls and you likely won’t have to touch a single share of stock because you’re in a spread trade and not truly “naked” (naked meaning not “covered” with long stock or a long call). The long call in this instance serves as a surrogate for the stock and provides equal protection in case the trade turns against you.
A bull-call spread is what’s known as a debit spread — meaning, you’re paying to enter the trade, but it’s significantly less than only buying the long call options in this spread, because you’re also taking in some premium by selling calls in this simultaneous transaction.
For instance, you can buy a July $40 Call for $2.50 and sell a July $45 Call for $1, which means your net debit will be $1.50.
In this example, you’ve “earned” $1 in premium upfront and have upped your odds in “winning” with your trade, as the spread concept provides a bit of a safety net and gives you more leverage in the markets.
The bull-call spread is just one of many strategies you can use to play the options markets, but if you have a positive outlook on the stock and also want to limit your downside as well as the amount of your investment, spread trading is a powerful tool to have in your arsenal. The caveat is that your profit potential gets capped, but while you might not “win big,” you also won’t “lose big” either.
Keep in mind that with any options trade, the most you can lose is as much as you put into it. And while we’re all playing to win, the losers hurt a lot less when there’s not very far to fall.