Option risks, dangers and opportunities should be avoided by new investors to prevent portfolio explosions destroying wealth and blowing up assets.
Managing Investment Market Risks, Lesson 10, explains why new investors should first learn stock market basics and gain experience needed to show investing results. Links at the end guide you to related content if you want to learn more.
What’s in this lesson for me?
The lesson teaches about option basics and the risks and dangers of misusing derivatives. Knowing options can destroy portfolios makes you aware of the risks so you can keep investments out of harm’s way.
Learn and do basics before options
Options have no place in the portfolio of anyone new to investing. Misused options are very dangerous financial explosives. Learn investing basics before you consider using options or any financial derivative.
Options are a type of derivative. Derivatives are financial creations “derived” or based on a real asset. They are bets that future prices for that asset will be higher or less.
Danger! Options are financial explosives!
Call it or put it, options confuse many beginning and average investors. This lesson helps clear the fog. Options come in two flavors, calls and puts. They are bets. Calls
Options are contracts giving you the right, but not the obligation, to buy (call) or sell (put) shares of a stock at a fixed price on, or before, the expiry date. The contracts are for lots of 100 shares.
Short term plays for profit
Options are short term plays to make short term money. For example, buying one call option gives you the right to buy 100 shares of a stock at a fixed price on or before the expiry date. If the stock does what you think and goes up in the short term, the call could be very profitable.
To profit from that call, the owner exercises the option. That means purchasing the stock at the call price. Then having purchased below the current market price the stock can be sold for immediate profit or held by anyone expecting it to go even higher.
Options can turn falling prices into profit
On the other hand, options can also make falling prices profitable. Should you think a stock will be going down, buying a put gives you the right to sell 100 shares of the stock at a fixed price on or before the expiry date.
As the opposite play to the call option, when puts win the bet on a falling stock price, the contract buyer profits. To realize a profit, the stock gets put to the contract seller who purchases at the contract price. As that price is above the falling price, put contract buyers can profit.
Pay to play options
Call or put option contracts have a premium cost as the fee for the rights. Premiums are determined by buying and selling demand. Winning the bet can be profitable fun but losing can have a high cost. There are several ways to get the bet wrong, even when you are right! For example, you have to get the direction, timing and price change right to profit. Falling short on any part of the bet produces a loss.
That complexity can make options dangerous for beginners. Trading options should be learned with an experienced guide. However, there are ways to get risks and costs under control and in your favor.
Secret of profitable covered call writing
Covered call writing can be profitable and low risk. It involves selling options on share you own. It can dramatically improve portfolio returns at low risk but does require that you pay attention and actively manage your portfolio.
This can be a reasonable, low risk and straightforward strategy, but again, I emphasize, not for beginners, in my opinion. Consider it an intermediate level strategy. First, become familiar and comfortable with investing in stock markets, then consider writing covered call options.
To use this strategy, covered calls can be written for stocks or ETFs that you own. You can get your financial advisor to do it or you can do it yourself using an online broker.
To use an online broker, begin by asking them to agree. Getting them onside takes some simple paperwork. However, if you are just getting established with a small account, the answer will be no.
Options have risks and obligations for your broker or online account. You will need a minimum amount of assets. Even with approval, most likely your account will be restricted to writing covered calls or selling put options. Those are considered the lowest risk options and all you need.
Options contract round lots
Remember, option contracts are for blocks or round lots of 100 shares. Each contract commits you to buy or sell 100 shares if the conditions are met. The covered call writing strategy works most reliably with large stable company stocks.
Such stocks typically trade sideways for long periods of time. That means most times during the typical option term of up to three months, the stock price often remains about the same.
When that happens, selling options for a price most of the time do not move much
Options are derivatives
Shares of say $50 may have 51 call option premiums of $
Shares of say $75 may have 76 option premiums of $
Shares of say $100 may have 101 option premiums of $
Premium prices can be small or huge but think something in the range of $50 to $350 per contract. There are many well outside that range.
As an example a $50
Sellers write, holders buy
all over the scale varies
As we know options are contracts and somebody has to create or write them. if you think a stock will move but you get the contract date wrong, you could lose the premium and still watch
When you make a losing bet the cost can be high. are on losing side of the bet
from the difference.
a put lets you put or force the contract seller to buy the stock get a bad rap as risky investments. Options can be risky and destructive especially when used to speculate.
However they can be used to reduce risk and to generate income. Both approaches can be managed at low or moderate risk. They do require attention and attendance.
Options can be more lucrative than equities
First, do your homework. Once you know what you are doing options can produce more revenue than trading stocks. That is trading, not investing. Trading requires you to pay far more attention and not have an off day. It is lucrative when done well but to consistently perform well demands attention, care and knowledge.
Chasing option income can be dangerous
One danger of boosting returns with covered call writing is a mind twist that can trip us up. After winning covered call bets time after time, it is possible to become I got this
Option advantages
- Options require lower upfront financial commitment than stocks
- Downsides can be limited
- Options have flexibility
- Options can fix a stock price
Option disadvantages
- Possible unlimited or exaggerated losses – option obligations have no limit.
- Option plays have absolute time limits
- Option traders have obligation to their broker
- Possible additional costs (margin accounts)
Someone new to investing asked this question
NO options no way – new investor danger!
Are options an option?
Link to Part 1, White Top View series, The option of options
Part 1 Are options an option?
Only consider using options after you become a knowledgeable and experienced investor. Be in no hurry to get there.
Options for Dummies may not be the complete how to guide but does a very good job of the basics. I urge you to start your research there to make sure you have the basics well in hand.
Options can turn nasty in a hurry!
You certainly need to pay attention and truly understand what they are and are not. Many small investors quickly have their pockets picked in the options market. Do your homework before going there.
Paper trading – practice or kidding yourself?
We love to win, we love to feel smart and making money is great! On paper it is all so easy! You can start by wasting some paper and pretending that you are trading.
If you do, at a minimum be honest with yourself. No ‘do overs’ or ‘only ifs’ allowed. Actually track your imaginary transactions.
When you paper trade options you can become a billionaire in short order! But it is not real. You are playing without true time or market pressure and using only your imagination in a static unresponsive market.
Of course it goes your way!
It’s only pretending! Yes, do paper trade to run through the process. It can teach you the mechanics of the basic action but can not give you actual trade experience.
To more closely resemble the real world, make certain you paper trade in real time, using real price quotes and real order depth.
Any time delay in your pretending gives you an artificial and unrealistic experience. Many books and “consultants” can seem very far away from reality to an experienced player’s eye.
When you actually do go live things are suddenly different. That’s when the real learning starts. It can involve both paying and pain.
Thin markets are financial quicksand – risky!
Know that at times specific option markets are notoriously thin. Newcomers can be surprised and may not realize how risky a thin market can be. Make a wrong move and you may soon feel like you dropped through thin ice into financial quicksand!
Thin markets mean that there are few others ready to buy or sell. You need trade action, trade volume and multiple buyers and sellers to have any reasonable hope of making a profitable trade.
Thin markets means buying or selling at a favorable price can be difficult. Spreads can be huge. Or seemingly reasonable spreads can quickly become profit swallowing chasms.
That means even if you got in when you wanted, at a price you find acceptable, getting out at a profit could be a challenge.
Sophisticated market risk
Be able to recognize and fully understand the price, volume and time risks before trading options. Blindingly fast price swings do happen.
Connected electronically or not, distance does make a significant difference. The pros are at the front of the line and well ahead of you. The implications must be well understood.
Your will never be first
You are going up against very knowledgeable and experienced players who are very willing to pick your pocket. They are armed with superior technology and positioned in front of you. Your dealer or their associate can be the other side of a trade while “serving” you.
Be aware of who gets paid and who gets to look over your shoulder. They do need to play both sides to make a market. They are doing this to make money, not to benefit you.
Pay especially close attention to lot size on each side as well as order number and depth on both sides. You do not want to be drawn into a losing trade by chasing a position that you can not possibly leave at a profit.
Numerous pro services are available online. For a price they are willing to help you. They will give you a very different story then what I say. They make their money by getting you to trade.
They are ready to collect your money for the assistance. It will be exciting but few newbies find it profitable for any length of time. No person I know stays with any but a very basic option program AND consistently makes money for any length of time.
Options do work
For hedging or insurance, yes to options. To chase any but minor covered call profits, no, as far as I am concerned. Using covered calls works but you have to be aware of all the implications and costs to net out ahead.
Experienced and knowledgeable players can profitably use far more sophisticated strategies. Doing so is years beyond any beginner.
Why this lesson matters
Knowing why new investors should learn and apply stock market basics while they gain experience before considering options helps produce good investing results. Understanding option basics, risks and dangers helps avoid misusing derivatives and destroying investments.
Key points to take away from lesson 4, Investing strategy option danger, includes:
Option risks, dangers and opportunities should be avoided by new investors to prevent portfolio explosions destroying wealth and blowing up assets.
- Dips give investors the opportunity for a checkup, review and hunt.
- First do a checkup on your portfolio holdings to decide if each should go or stay.
- Second, investors can review their holdings and decide if they should add more to any holding at a discount price.
- Dips put the stock market on sale at discount prices so any pending portfolio additions can be added at a price discount.
- Third, use corrections to check the market for buying bargains.
- Dip buying should be done on the upside.
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Managing Investment Market Risks, lesson links:
Introduction to Managing Investing Market Risks Lesson 1
Dangerous dividend warning signs Lesson 2
Investor retirement saving dangers Lesson 3
Exotic ETFs blow-up portfolios Lesson 4
Stock scam awareness defense Lesson 5
4 Stock scam tips Lesson 6
Bitcoin fraud trust and psychology Lesson 7
Investors hold patient cash Lesson 8
3 Risk or opportunity signals Lesson 9
Option risks, dangers and opportunities Lesson 10
Cautious look at options Lesson 11
Selling low melts wealth Lesson 12
Next lesson 11:
Cautious look at options
Have a prosperous investor day!
Bryan
White Top Investor
[email protected] WhiteTopInvestor.com
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