I have a good general rule for life…<\/p>\n
“Don’t be stupid.”<\/p>\n
And this rule is especially good for option traders.<\/p>\n
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…<\/p>\n
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.<\/p>\n
But like most good ideas on Wall Street, options quickly turned into vehicles to “get rich quick.”<\/p>\n
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. We overleverage.<\/p>\n
And then we blow up our accounts.<\/p>\n
That’s stupid. And, that’s also why many folks who’ve traded options this way will tell you that option trading is risky.<\/p>\n
But, it’s not the option that’s risky. Let me explain…<\/p>\n
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.<\/p>\n
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.<\/p>\n
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.<\/p>\n
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.<\/p>\n
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.<\/p>\n
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