When you hear people brag about huge investment returns you have to consider how much risk they took on to get those gains. Traders who take huge risks often get hit with tremendous losses that destroy all of their gains.
Many investors get excited about options trading because they love the leverage they wield when the investment goes well, according to options trading information. While investors might make 10% or 20% returns on a stock, options traders can make a 1,000% return in the same time frame.
Those types of returns are achievable because of the leverage that options trading provides. The savvy options trader recognizes that he or she can control an equal number of shares as the traditional stock investor, but for a fraction of the cost.
The less-savvy trader might not realize the leverage they already wield and decide to spend as much money as they would have spent to establish a long stock position and invest it all in a huge options position. A tremendous benefit of trading options is limiting one’s risk, not multiplying it, as this would do.
Any investing carries a certain amount of risk. Options come with greater risk, so you should make sure you understand them before you get started.
The principal drivers of options value are changes in the price of the associated stock, changes in volatility and the passage of time. When you open your trading account with your broker, make sure you read the risk disclosures associated with gaining the broker approvals for options trading.
Without going into a discussion of the options Greeks (e.g., delta, theta, vega), the risks described below are what we believe to be the most common in options trading.
Risk #1: Time Isn’t Necessarily on Your Side
All options expire — most at zero value. Unlike stock investing, time is not your friend when you’re trading options, because options suffer from time decay. The closer an option gets to expiration, the faster the premium in the option deteriorates. This deterioration is very rapid and accelerates in the final days before expiration.
As an options trader, you should invest only a dollar amount that you are comfortable losing, because you may lose it all.
There are three things you can do to put time on your side:
1. Buy options that at or near the money.
2. Trade options with expiration dates that comfortably encompass the investment opportunity.
3. Buy options where you believe volatility is underpriced and sell options where you believe volatility is overpriced.
Risk #2: Prices Can Move Very Quickly
Because options are highly leveraged investments, pricing moves very fast. Options pricing, unlike stocks, can move by giant amounts in minutes or seconds rather than hours and days. Small movements in a stock can translate into big movements in the underlying options.
So, how can an options trader make money unless he or she watches the options pricing in real-time all day long?
You should look to invest in opportunities where you believe the profit potential is so robust that pricing by the second will not be the key to your making money.
In other words, expect to go after such large profit opportunities that there will be plenty of reward if you are not precise in your selling.
Additionally, do all you can to structure the options purchase using the right strike prices and expiration months so that much of this risk is reduced.
Risk #3: Losses Can be Infinite on Short Positions
What makes shorting options (which is also known as selling volatility) tantalizing is the possibility of having infinite gains. Much of the professional investment world has achieved gains from selling implied volatility, as implied volatility has typically been higher than realized volatility.
If the previous sentence sounded foreign, do not spend too much time worrying about it. Bottom line: You should not go after naked short options often. But when you do it, it should be because you believe the risk-versus-reward balance is extraordinarily attractive and should be captured.
How to Limit Your Risk When Trading Options
We strongly recommend that you start small at first. Get a feel on a personal level for what types of outcomes are possible. Make sure you are investing only an amount of money you are willing to lose entirely.
When you enter your options trades with your eyes wide open and your expectations more realistic, you will be better at managing your trades and, in turn, your risks. We strongly recommend that you put no more than 3% to 5% of your portfolio into a single trade. This way if the trade goes against you, you’re not going to lose your shirt and can recover from the loss.
Another great way to become familiar with option trading is to paper trade. This will help you gain some skills and confidence without risking your money.
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