Andrew’s Note: Happy Holidays from Jeff and the team. As some readers may know, during the holiday season our offices close down for two weeks. We’ll resume our normal publishing schedule on January 3.
In the meantime, we’ll be running a series of Jeff’s most popular essays. So kick back, relax, and enjoy some market wisdom from Jeff.
And now, read on to find out a stupid mistake most traders make…
Don’t do stupid things.
That’s a good rule for life in general. But, it’s an especially good rule for option traders.
Like most good rules, though, we don’t really understand their importance until we break them. And when it comes to trading options, doing stupid things can be an expensive lesson.
For example, it’s stupid to use options to overleverage a position.
The options market was created so investors could reduce risk. Options allow investors to hedge their positions, and to risk much less money than if they bought a stock outright.
But like most good ideas on Wall Street, options quickly turned into vehicles to “get rich quick.”
So, we forget about the “risk” side of the equation, and we focus only on the “reward” side. We get caught up in the allure of fast gains. We take on bigger positions than we should. And then we blow up our accounts.
That’s stupid. And, that’s also why many folks who’ve traded options this way will tell you that option trading is risky.
But, it’s not the option that’s risky. It’s the strategy…
Let me explain…
Let’s say you have $10,000 to invest. You can choose to buy 100 shares of Company X at $100 per share. Or you can buy one call option contract – which gives you the right to buy 100 shares of Company X – for, let’s say, $400… and leave the remaining $9,600 in your account.
If Company X’s stock goes up, you’ll make money with the call option since it allows you to buy 100 shares. If the stock goes down, you’ll lose money. But the most you’ll ever lose is the $400 you paid to buy the call option.
Even if Company X’s shares drop by 20% or more, the biggest hit you’ll ever take is that $400. Your remaining $9,600 is still sitting in your account.
Yes, losing the entire $400 you spent on the call option is a 100% loss on the trade. However, that’s still a more favorable outcome than potentially losing 20% or more of the $10,000 you’d risk if you had bought the stock.
This is a simple example. But, it’s the simplicity that proves my point. Options allow you to reduce your risk on a stock trade, while allowing you to profit just as much.
But that benefit disappears if you overleverage the trade and take on a larger position with options than you’d otherwise take with the stock.
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That’s the biggest, and stupidest, mistake most option traders make. Instead of replacing a 100-share purchase with one call option, they take the entire amount they would’ve allocated to the stock and buy a much larger position with options.
In other words, instead of buying one $400 call option to reduce the risk of a $10,000 stock trade, a foolish trader will take the entire $10,000 and buy 25 call options. What would have been a 100-share purchase has turned into control of 2,500 shares.
Instead of using options to reduce risk, this trader has increased their risk by 25 times.
Losing 100% on an overleveraged trade would be a disaster. And, it’s why so many folks think options trading is dangerous – because they’re doing stupid things.
Options trading isn’t dangerous if you use options the way they were originally intended – as a way to reduce risk.
Remember, limit your options exposure to control just the number of shares you’d would normally purchase. Leave the rest of the money in the bank. Then it won’t be so bad to lose 100% on an option trade.
It’ll almost always turn out better than what you could’ve have lost on the stock.
Best regards and good trading,
Jeff Clark
Reader Mailbag
Why did you start trading options? Did you use it to reduce risk?
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