Let\u2019s 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 \u2013 which gives you the right to buy 100 shares of Company X \u2013 for, let\u2019s say, $400\u2026 and leave the remaining $9,600 in your account.<\/p>\n
If Company X\u2019s stock goes up, you\u2019ll make money with the call option since it allows you to buy 100 shares. If the stock goes down, you\u2019ll lose money. But the most you\u2019ll ever lose is the $400 you paid to buy the call option.<\/p>\n
Even if Company X\u2019s shares drop by 20% or more, the biggest hit you\u2019ll 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\u2019s still a more favorable outcome than potentially losing 20% or more of the $10,000 you\u2019d risk if you had bought the stock.<\/p>\n
This is a simple example. But, it\u2019s 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
But that benefit disappears if you overleverage the trade and take on a larger position with options than you\u2019d otherwise take with the stock.<\/p>\n
That\u2019s the biggest, and stupidest, mistake most option traders make.<\/p>\n
Instead of replacing a 100-share purchase with one call option, they take the entire amount they would\u2019ve allocated to the stock and buy a much larger position with options.<\/p>\n
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.<\/p>\n
Instead of using options to reduce risk, this trader has increased their risk by 25 times.<\/p>\n
Losing 100% on an overleveraged trade would be a disaster. And, it\u2019s why so many folks think options trading is dangerous \u2013 because they\u2019re doing stupid things.<\/p>\n
Options trading isn\u2019t dangerous if you use options the way they were originally intended \u2013 as a way to reduce risk.<\/p>\n
Remember, limit your options exposure to control just the number of shares you\u2019d would normally purchase. Leave the rest of the money in the bank. Then it won\u2019t be so bad to lose 100% on an option trade.<\/p>\n
It\u2019ll almost always turn out better than what you could\u2019ve have lost on the stock.<\/p>\n
Best regards and good trading,<\/p>\n
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<\/p>\n
Jeff Clark
\nEditor, Market Minute<\/em><\/p>\n