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Understanding Options Risk

How to Trade Options GuideBy understanding risk, you can become a better and more profitable trader.

Many investors get excited about options trading because they love the leverage that is possible when an investment goes well. While stock investors might make 10% or 20% returns on a stock, aggressive options investors could potentially make a 1,000% return in the same amount of time.

What Are Options?
What Are Options Contracts?
Price of Options
How to Read Options Symbols
How to Price Options
How to Read Options Quotes
Understanding Options Risk
Common Mistakes to Avoid
Options Trading Strategies
Choosing an Options Broker

Those types of returns are achievable because of the leverage offered by options trading. The savvy options trader recognizes that he or she can control an equal number of shares as the traditional stock investor for a fraction of the cost.

Less-savvy traders 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 into a huge options position. For example, instead of spending $3,000 to buy 100 shares of MSFT at $30, one might spend $3,000 in MSFT options. With options trading, no one needs to spend like this.  One tremendous benefit of trading options is limiting one’s risk, not multiplying it, as this would do.

A good rule of thumb to use is not to invest more than 3% to 5% of your portfolio into any one trade.  For example, if you had a trading portfolio of $25,000, you would only use $750 to $1,250 per trade.

Trading options is NOT about merely trading risk for equal reward. Instead, your goal is to gain a professional trader’s edge. You should seek to reduce risk through careful selection of investment opportunities and, at the same time, capture bigger returns. There will be losses, for sure. But ultimately every trader’s goal is to shift the ratio of winners-to-losers to favor strong and profitable portfolio returns.

Any investing carries a certain amount of risk. Options investing assumes greater risk, so you should make sure you understand the pros and cons of the strategies you are considering before you start actively trading.

Without going into a discussion of the Greeks (e.g., delta, theta, gamma), the risks described below are among the most common in options investing. When you open an options trading account, you’ll receive a complete guide of options trading risks from your broker.

Time Isn’t Necessarily On Your Side.

All options expire — most at zero value. Unlike stock investing, time is not your friend when you are holding long options. 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 investor, you should invest only a dollar amount that you’re comfortable losing, because you could lose it all.

There are three things you can do to put time on your side:

• Buy options at the money (or near the money).
• Trade options with expiration dates that comfortably encompass the investment opportunity.
• Buy options at a point where you believe volatility is underpriced, and sell options when you believe volatility is overpriced.

Prices Can Move Very Quickly.

Because options are highly leveraged investments, prices can move very quickly. Options prices, unlike stocks, can move by hefty amounts in minutes or seconds rather than hours or days.

Depending on factors such as time until expiration and the relationship of the stock price to the option’s strike price, small movements in a stock can translate into big movements in the underlying options. So how can an options investor make money unless he or she watches the options pricing in real-time all day long?

Answer: You should invest in opportunities where you believe the profit potential is so robust that pricing by the second will not be the key to making money. In other words, go after large profit opportunities so there will be plenty of reward even if you aren’t 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. Depending on your personal risk tolerance, you might also consider closing your option trades with enough time before expiration that time value isn’t deteriorating so dramatically.

Losses Can Be Substantial On Naked Short Positions.

Much like shorting stocks, shorting options naked (i.e., selling options without hedging the position via other options or a stock holding) could lead to substantial and even unlimited losses.

Naked short in options means you’re selling a put or a call by itself, without securing it with cash or another stock or option position. You might be wondering how else you could sell a put or a call. Many investors prefer to sell puts or a calls in combination with stock or with other options. This removes the potentially unlimited risk of the “naked” put or call that is being sold. The covered-call section below is an example of this kind of strategy.

Although many will use the word “short” to describe selling options to open, it’s not exactly the same structure as shorting a stock. When you short a stock, you’re selling borrowed stock. At some point in the future, you have to return the stock to its owner (typically by way of your broker). With options, you don’t borrow any security. You simply take on the obligations that are associated with selling options in exchange for the premium payment.

What makes shorting options naked (which is also known as selling volatility) tantalizing is the possibility of having a steady source of gains. Much of the professional investing world has booked gains from selling options, as the underlying stocks have been less volatile than what their options premium was implying.

For example, if we sold near-the-money 12-strike May puts in Ford Motor (NYSE:F) and collected 58 cents, we would keep this premium if the stock remained above $12 per share through May expiration. The short put achieves its maximum potential profit if Ford moves higher, stays put, or even falls slightly to the 12 strike. Much of the time, stocks don’t move as much as investors would expect.

There’s an important difference between selling to open a call naked versus a naked put. When you sell a naked call, your theoretical risk is infinite. You’re on the hook for the difference between the strike price and the amount the stock moves above this price. Because there isn’t a limit to how high a stock can trade, your potential loss is infinite.

However, when you sell to open a put naked, your maximum loss is the difference between the strike price and zero. Risk for a sold naked put is the same downside risk as owning the underlying stock at the strike price. In other words, stocks cannot trade below $0, so your potential loss is capped, though for some high-priced stocks, a fall down to $0 might seem virtually unlimited!

Selling puts naked can be an excellent way to have long exposure to a stock at a better price. You may be eyeing a stock, but the stock always seems too expensive. Rather than chasing the stock price, you can sell a put, collect the premium for doing so, and become long the stock at your strike price if the shares move to that strike price.

For example, you may have wanted to own Microsoft (MSFT) during one of its market rallies, but paying more than $30 per share seemed excessive. Rather than pay that much, you could sell the MSFT October 30 puts for $1.50. You collect this premium today, and your effective cost for MSFT if you are obliged to buy the stock (or “put to” the stock) is $28.50 ($30 strike price minus the $1.50 collected).

If you are interested in the put-selling strategy, it is recommended that you start small. Get a feel on a personal level for what types of outcomes are possible. Make sure you’re investing only the amount of money you’re willing to lose entirely.

When you enter your options trades with your eyes wide open and realistic expectations, you’ll be better at managing your trades and, in turn, your risks. Again, only put 3% to 5% of your trading funds into each trade. That way, if the trade goes against you, you’re not going to lose your shirt and be unable to rebound from the loss.

Another great way to become familiar with options trading before you use real money is to paper trade, which means you’re tracking options trades “on paper” from start to finish without investing any money. This will help you gain some skills and confidence without risking your money until you have a better understanding of how options trading works. One easy way to “paper trade” is through a virtual account at your online broker.

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