Nick’s Note: Jeff Clark is one of the best options traders I know. Many readers think options are complicated and confusing. But trust me, after reading Jeff’s essay, they won’t seem complicated at all. Personally, I buy and sell options in my personal account. It’s my main method of placing short-term trades.
Read on to see how Jeff uses options to reduce his risk.
Most folks say options trading is risky.
Most folks don’t know what they’re talking about.
Novice traders often don’t take the time to learn the right way to use options. They jump right in thinking “I got this.” They gamble, blow up their accounts, and then walk away penniless and swearing off options forever.
Even experienced traders sometimes get caught up in the allure of fast gains. They overleverage their positions—take a bigger position size than they should—and then take a hit. All the options traders I know, including myself, have blown up their accounts at least once.
But it’s not the option that’s risky. It’s the strategy. When used the right way, options are far less risky than trading stocks.
Let me explain…
Most people use options the wrong way. Most people use options to increase leverage… to get more “bang for their buck.” In other words, most people use options to increase risk.
That’s wrong. That’s the exact opposite of what options were designed for.
The options market was created so investors could reduce risk. Options allow investors to hedge their positions… and to risk much less money than they would if they bought a stock outright.
Let’s say you want to buy stock in Company X. It trades for $10 a share. You could put up $1,000 to buy 100 shares… But you can control the same amount of stock with one option contract. You can buy a contract for, let’s say, $50… and leave the other $950 in your account.
If Company X’s stock goes up, you’ll make money. If the stock goes down, the most you’ll ever lose is that $50. That’s a 100% loss… but it’s a lot less than potentially losing 20% or more of the $1,000 you would risk if you bought the stock.
This is a simple example. And it’s the simplicity that proves my point. Options allow you to risk much less and profit just as much as you would buying stocks.
But that benefit disappears if you overleverage the trade and take on a larger position with options than you would otherwise take with the stock.
That’s the biggest mistake most novice options traders make. Instead of replacing a 100-share purchase with one call option (an option that gives you the right—but not the obligation—to buy or sell a particular stock at an agreed-upon price at a set time in the future), they take the entire amount they would have allocated to the stock and buy a much larger position with the options. And they break the 11th commandment of trading: “Risk not thy whole wad.”
Rather than buying one call option for $50 and leaving the remaining $950 in the bank, novice traders take the entire $1,000 and put it into buying more call options.
They end up buying 20 call options to try to get more bang for their buck. What would have been a 100-share purchase has turned into control of 2,000 shares. Instead of using options to reduce risk, they’ve increased their risk 20 times.
Losing 100% on an overleveraged trade would be a disaster. And it’s why most folks think options trading is dangerous. But it’s not dangerous if you trade options the way they were originally intended… as a way to reduce risk.
Limit your options exposure to control just the number of shares you 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 will almost always turn out better than what you could have lost on the stock.
Best regards and good trading,
Editor, Delta Report
P.S. If you haven’t heard, I just released my new “profit windows” trading system. It’s the product of over five years of research… And it has a 90.2% success rate… 50% average gains… and an average trade length of just two days. You can click here to learn more.