The benefit to buying either calls or puts is that you use as little money as possible to generate large returns. I’m sure you’ve heard the horror stories about speculating with options. Many people are afraid to consider options because they believe they are too risky, too complicated, or that you could lose your entire investment. There is some truth to these opinions if you don’t use options properly or if you don’t follow certain risk-management rules.
If you are willing to take the time to learn just the most basic two strategies (buying calls or puts), and follow the five rules listed below, you can bring in decent profits with less risk than if you had bought stocks. It’s hard for many people to believe that trading options is often less risky than trading stocks, but it’s true. In fact, the best part about buying single options is that your risk is limited while there is tremendous upside reward.
Another advantage when buying calls or puts is the low cost. For example, instead of paying just over $22,000 for 100 shares of Apple AAPL, -0.46% stock (at current prices), you might pay between $500 and $800 for one call or put option (100 shares of stock = one option contract).
If you are right about the direction and timing of Apple, you can make many times your initial investment. If wrong, the most you can lose is all or part of the initial investment. Don’t get me wrong: it takes a lot of practice and studying to learn to get the direction and timing right. Learning how to trade options is like learning a new language. For those willing to take the time to learn, and follow the rules, it can bring in decent profits.
If you’re interested in learning more about options, here are five important risk-management rules to get you started. A failure to follow these rules (and others) can cause you to lose money, so before you make your first trade, read them carefully. I created these rules based on the many mistakes I made when I first started trading.
The following five rules should help you to reduce risk:
- Start by learning only three option strategies: Although there are dozens of option strategies, start with only three: First, sell covered calls if you own stock and want to rent shares to option buyers. This strategy works best with low volatile stocks. Next, buy call or put options. Since every option strategy is based on buying calls and puts, it’s essential you master the basic strategies first. Hint: It can take one to two years to fully learn even the basics.
- Focus on trading options on only one or two indexes or stocks: If you are new to options, consider trading index options such as SPY or QQQ rather than buying options on individual stocks. The indexes often move more slowly than individual stocks (not always, but often), and they are often less expensive than buying options on stocks. No matter whether you buy options on stocks or indexes, keep your trading universe small.
- Use less money: No matter how much is in your trading account, do not trade with more than $2,500. This allows you to buy between 1 and 5 option contracts (equal to buying 100 and 500 shares of stock). The biggest mistake many people make when first starting out is speculating with too much money. Once you start “doubling down” on your option positions, you cross the line from trading to gambling. Limit the amount of money you trade so you aren’t tempted to bet it all on one trade (that’s how traders lose all their money). Consider the $2,500 (or less) as tuition money. You don’t need to trade with a lot of money to make a decent profit with options.
- Not everyone should trade options: Keep in mind that “less risk” does not mean no risk. If you get emotional about winning or losing, if you have a gambling personality, or if you don’t have the time to watch your options positions, then you might want to invest in stocks, mutual funds, or index funds and avoid options altogether.
- Read and practice: Learn how to trade options by taking introductory online classes or free seminars with the OIC (Options Industry Council) or the OCC (Options Clearing Corporation) at various locations around the United States. If you have questions about options, you can also call the OIC at 1-800-OPTIONS Monday through Friday during market hours. Avoid expensive classes that teach complex speculative strategies. You can also buy books on trading options online or at a local bookstore.
Keep it simple and don’t rush
To review, most beginners only need to learn three option strategies: The two basics — buying calls and buying puts — along with selling covered calls. Start with less than $2,500 (you can open an options account at a brokerage firm for less than $100), focus on a small universe of stocks or indexes, and continue to practice trading with a limited amount of real money.
There is a high likelihood you will lose money when you are first starting out, which is why it’s so important to start small. After a few weeks or months, you will either find that options are not for you, or that they’re a way for you to boost income. Just don’t rush in with too much money and too little knowledge.