There is a general misconception in the trading community that an option trading is very risky. Options can be risky, but they don't have to be. Options
There is a general misconception in the trading community that an option trading is very risky. Options can be risky, but they don’t have to be. Options can be less risky or more risky, depending on your risk tolerance. They can be used for speculation, but also for hedging, protection, leverage etc. There is more than one way to make money with options. Here are some of the common myths and misconceptions about options trading.
I see too many “gurus” promise to make you money with no effort, charging thousands of dollars in the process. They present some of the highest risk strategies (like trading weekly options) as “low or no risk”.
The truth is that learning how to trade and invest successfully requires a lifetime of work, dedication, and focus. Not only is there a long and difficult learning curve just to learn the basic fundamentals, but you’ll soon discover that being a student of the markets never ends. To become an engineer you have to study 4 years, and probably another 4 years (at least) to become a good one. Why people expect it to be different in trading?
This is a very common misconception. While it is true that buying calls or puts can be very profitable, it is also a more risky way to trade. When you buy calls or puts, you have to be right three times:
The underlying has to move in the right direction, and fast. You can predict the direction and the size of the move right, but if the move happens after the options expired, you lose money. Even if everything works in your favor, but Implied Volatility collapses (after earnings for example) you might still lose money.
The truth is that options can be used in many ways. They can be used for speculation, but also for hedging, protection, insurance policy, income etc. For example:
Did you know that selling naked puts has the same P/L profile as selling covered calls? Yet most brokers allow traders to sell covered calls in their IRA accounts, but not naked puts? I find it extremely ignorant. An alarming number of financial professionals, including stockbrokers, financial planners and journalists are in position to educate the public about the many advantages to be gained from adopting naked put writing (and other option strategies), but fail to do so. Many public investors never bother to make the effort to learn about options once they hear negative statements from professional advisors.
Writing naked put options is a significantly more conservative strategy and definitely less risky than simply buying and owning stocks. As such it deserves to be considered as an attractive investment alternative by millions of investors.
According to The Chicago Board Options Exchange (CBOE) here are the facts:
The CBOE goes on to point out that having an option expire worthless says nothing about the profitability of the strategy that it may have been part of. Multi-legged strategies can often require that one leg or more expire worthless although the strategy as a whole is profitable.
The truth is that both option buyers and sellers can profit from option trading. If only sellers made money,
there would be no buyers. With no buyers there would be no market. While options selling does have an edge in many cases, it also exposes you to negative gamma.
As Mark Wolfinger wrote: “Premium buying is the less-traveled road, but it can be profitable for the well-prepared, disciplined trader. It doesn’t mean it is better or worse than premium selling. It just means that there is more than one road to Rome.”
The truth is that options may be used as insurance policies. They can be used as risk management tools, not only trading vehicles.
As Mark Wolfinger explains here: “If I buy a call option and earn a profit by selling at a higher price, there is no reason to believe that the seller took a loss corresponding to my gain. The seller may have hedged the play and earned an even larger profit than I did. I don’t see anything resembling a zero sum game in hedged options transactions. I understand that others see it as black and white: If one gained, the other lost. But that’s an oversimplification.”
The key to success in options trading is using mix of diversified options trading strategies, like straddles, calendars, iron condors etc. In my opinion, you can rarely succeed in options trading by buying some cheap out of the money options and “hoping” for a big move.
This is a guest post written by Kim Klaiman. Kim Klaiman is a full time Options Trader and founder of steadyoptions.com – options education and trade ideas, earnings trades and non-directional options strategies.
Read more from Kim on his Options Trading Blog.
Twitter: @SteadyOptions