Options Crazy

[Leth]

Options are the sexiest thing to hit the stock market ever since…well…the beginning of the stock market. Why do options have such curb appeal?
The answer: Leverage

For more information on the basic logistics of options, please read the thread entitled Introduction to Options.
http://www.trading-lab.com/forums/in...ions-t286.html

Options allow a trader to buy a decent block of stock for an average of 1/10th the price. For example: If Microsoft is trading at $26.00 and you buy 100 shares outright, you’re going to spend around $2,600.00. However, if you buy an option contract on Microsoft (1 option contract controls 100 shares), you may only end up spending approximately $260.00. Obviously, the reverse is true for going short. This is what I find to be as one of the advantages of options, especially if you’re starting out with a smaller account. What I mean by this is; in order to short stocks outright, a brokerage firm will usually require at least a $5,000.00 account balance in order to cover any losses due to margin calls. Going short options (buying puts) will not have such requirements because margin is not used.

However, as sexy as options appear, they do have a major enemy….time decay. As if traders didn’t have enough pressure as it is, now we have to worry about beating the clock. This is the price you pay for leverage. Futures traders are no stranger to the combination of time decay and leverage; they have been implementing these tools for years. So what’s the major difference between futures and options? Futures traders have the same type of leverage as option traders, with the exception that futures traders use margin. This means that if a position goes against you, and proper money management is not used, you can actually end up in the hole. With options, you can never lose more than the price you paid (premium) for the contract. I don’t know about you, but from a risk standpoint, I'd rather keep my shirt trading options than give it to someone else by trading futures.

How should one trade the options market? The answer is easy: As simply as possible. There are as many books and methods on trading options as there are traders. And some of the books are as thick as a mattress (obviously I’m embellishing a bit, but needless to say, it sure seems like it). For example, there are naked puts, covered calls, straddles, option writing, Black Scholes formulations, etc. I personally tend to let the market professionals and insiders deal with that aspect of the options market. Trading options in its simplest form is by the use of calls and puts. Really, why would anyone want to overcomplicate things? That’s only my opinion of course.

As you already know, more risk is involved with options trading than the standard buying and selling of stocks outright. Therefore, the best way to control this risk would be by cutting back on your position size. For instance, if you have 5 stocks in your portfolio and 10% of your total trading capital goes into each stock trade; you might want to think about scaling back to 2 – 5% of your total capital per trade when trading contracts. Options can easily be traded by day traders, swingers, momentum traders, and trend followers alike. This being the case, your allotment of risk capital per trade may highly depend on your actual style. Also, you can trade options on pretty much any type of security the market has to offer.

There is a plethora of information out there you can use to help you find an options trading method that's right for you. Try not to be too quick in jumping on the options bandwagon without first getting your feet wet in less riskier strategies. Remember, as with any type of trading; discipline, homework, risk management, and patience are the keys to success.



*Disclaimer: Your personal choice in trading methods should be based on your evaluation and understanding of risk. The author of this article (Leth) is not liable for any personal losses accrued.

[aiki14]

I'd like to add a couple things about options that may be helpful to folks not familiar with them. As Leth correctly points out they can add significant risk to your portfolio but they can also reduce risk.
I trade options frequently and use them predominantly to hedge against moves in stocks where I hold long positions, or to add income when I believe a stock is rangebound.
The first scenario is this:
You have a position in XYZ that has given you a 10% profit, you can buy puts that may cost you 3% of that and thereby "lock in" a minimum of 7% profit, thus allowing you to hold the long stock position if you believe further upside is forthcoming, without incurring additional risk.
The second scenario is this (before I continue I wish to respectfully correct Leth on one thing, going "short" options generally means to write the options, which is very different than buying puts):
You believe a stock to be rangebound, you can write (sell) both puts and calls on it. Let's say XYZ is trading at 20 and you believe it will stay there for a while. You sell the 15 puts and the 25 calls and pocket the premium, the options expire and you are ahead that premium. The drawback here is if the stock goes below your put price you have the 15 at risk and if it goes above your call price you have UNLIMITED risk. This type of strategy is usually restricted to investors with experience and high account values. Merrill Lynch requires 250k and E*Trade 100k to take options positions with unlimited risk, your broker may differ but probably not by much.

I would recommend "The complete Options Player" by Ken Trester as a good reference text for those looking to play options. You may want to start out with something more basic, but I don't have any specific experience with anything I could recommend to an absolute beginner.
I would urge extreme caution with options at any level, whether buying calls and puts or playing exotic options strategies. It is even more important that you have a good understanding of the basic concepts before taking on the added risk.

[Leth]

I stand corrected. You are right Aiki. I should have phrased that differently. I should have said , "when short on the market, you can buy puts." I should not have said "go short options by buying puts."
Options are a bit difficult for me to explain since I dont look at options themselves as a market (e.g. the options market) or use them as a hedging strategy. I use them as a leverage tool (l.e.a.p.s.) since im a long term trader. Your insight is helpful.

Leth