This Article & Video some key details of Trading Stock Options – especially –
How Stock Options Trading Works & Risks & Rewards
The Difference between Stocks vs Options
Included are my Top 11 Tips and Mistakes to avoid.
Recently I received an email from a registered student regarding Stock Options.
He asked me
“Do you have a system that can help me make money in Stock Options”
He had invested in training, but the training was mostly about how to follow a specific stock options system.
My reply was:
“My advice to you is to invest in your education so you can truly understand how to evaluate stocks and how to make decisions on the future direction of a stock. Also before you use options you need to be able to make money with regular stocks.
Options have risks (time is always against you) and you need to be able to judge the direction of the stock market as well as the direction of an individual stock.”
Trading Stock Options – A simple example
Stock Options are simply a vehicle to achieve a goal. For those people who cannot use leverage to increase their total investment pot, Options are a cheap and effective way to leverage your invested capital.
For example. I have $1,000 to invest.
Strategy 1 – Buy the Stocks
I could buy 5 shares of AMZN at $198 per share. Total Costs $990 + trade costs.
If Amazon (TickerAMZN) moved up 5% over the next 2 months to $207.90.
My profit would be $9.90 per share = $49.50
Strategy 2 – Buy Options on the Stock
I could buy 1 Out of the Money Call Contract for AMZN with a strike price of 200 and an expiry date of May 21 2018
In options speak:
- 1 contract means I will have control over 100 shares of AMZN
- Out of the money means the strike price of $200 per share has not been reached
- Strike price is the point at which the option will have a value (apart from the time value)
- Expiry Date is the date on which the option Contract expires and loses all value.
In the same scenario as above the stock price moves 5% to $207.90. The difference in price is $9.90 per share.
Theoretical profit would be 100 X 9.90 = $990. This means a gain of 100%.
I say theoretically because when you buy an option the clock starts ticking on the time value. If the stock price took 2 months to move to $207.90, then you would have lost all of the time value of the contract which would dramatically reduce your profits. However, if the stock had moved 5% in 1 day you would have secured almost all of the 100%.
What are the risks of Options compared to simply buying the stock?
If the stock price moves against you, you can lose the entire investment. With stocks, this is quite rare. If the stock price does not move at all in the time period, your investment can also expire worthless.
So in order to share some of my experiences with Options, I have created this Top 10 Tips
11 Core Tips for Stock Options Trading Success
Tip 1 – Understand Technical Analysis
Before trading a single Stock Options Contract you need to understand Technical Analysis. Not only that, you must have a strategy that pays off. This means you must have already developed a profitable stock market strategy through which you make a profit. If you cannot make money in stocks, thenyou will lose all your money quicker with options.
Tip 2 – Understand Fundamental Analysis
The fundamentals of a stock do have an impact on the direction of a stock. You need to know what makes a company a good investment and what makes it a bag of garbage. Do not bet against the fundamentals
Tip 3 – Time Counts Against You
You need to be sure before placing an Options Contract that the stock is going to move before the contract expires. You will look for more volatile stocks or at least stocks with a strong trend and increasing volume.
Tip 4 – In the Money Options, Out of the Money Options
Understand the additional costs of buying an option in the money as opposed to out of the money. When you buy an “In the Money Option” it means there is already some intrinsic value in the contract. This you will pay for in the contract price. Alternatively “Out of the Money Options” are cheaper, but it does mean that the stock price has further to move before the strike price is hit and the option’s intrinsic value is improved.
Tip 5 – Understand Calls & Puts
A Call Contract means you expect the stock price to increase and therefore seek a profit relating to the increase. When you buy a PUT Option it means you expect the stock price to fall and therefore realize a profit based on the decrease. This is rather like shorting a stock. You need to be sure of the direction of the stock.
Tip 6 – Buying Calls & Puts
If you are new to Stock Options Contracts you really need to be a Buyer of Contracts. In this way, you limit your risk to the amount you have bet on the contract. Unless you have expert professional skills you should only be a buyer of contracts.
Tip 7 – Selling Calls and Puts – Don’t Do It
If you are the seller of an Options Contract you have the benefit that time is on your side. Your goal is that the option expires worthless. Your reward is simply the value you get from the Contract you have underwritten. However Beware, as a seller of contracts you are taking huge risks, because you will need to pay out an almost unlimited amount if the stock skyrockets and you sold a Call Contract. Also if the stock price plummets and you sold a Put Contract you will also have huge liabilities.
Tip 8 – Don’t Get Too Complex
When you attend a seminar on stock options they will fill your head with all sorts of complex strategies like Vertical Spreads, Straddles, Bull Spreads, Bear Spreads and Box Spreads. If you make your trading complex you will not make any money. Keep it simple.
Tip 9 – Liquidity Matters
Before buying any Options check what the open interest is. This means try to find out if there is a liquid market in the contract. There is nothing worse than buying an Options Contract and then you have the shock that it is immediately almost worthless because no one is trading it and no one wants to buy it.
Tip 10 – Profit Volatility
Be ready to see some serious fluctuation in the profits or loss on an option. Sometimes I see wild swings in potential returns. An option can show a 25% profit in a few minutes, only to show a 20% loss a few hours later. An option is a leveraged investment that magnifies your gains and losses.
Tip 11 – Cash Allocation
Do not place your entire investment pot on any single Options Contract. Use only a portion of your money on options and of that portion do not invest more than 10% or 20% in any one contract. Remember if your contracts expire worthless and you lose all your money, then you have no more chips and you have to leave the table. You do not want that.
Options are a great tool for magnifying your rewards, but you really need to be a successful stock trader before investing in Options. Learn how to make money in stocks before you use any leverage on your portfolio. Try the Liberated Stock Trader PRO Training before you research Trading Options.
Also, great book to learn more about options is Getting Started In Options by Michael C. Thomsett in our 20 Best Stock Investing Books