Trading Options: What Are You Trying to Accomplish?

When some investors hear about 'options' they get very excited and can't wait to begin trading.  That's usually the result of hearing some ultra-hyped commercial that promises fantastic profits.  Unfortunately those profits are seldom realized.

On the other hand, I recently heard from someone who has always been steered away from options because he had been taught that options were 'too risky.'  After reading some of my writings, including my recent book, he now believes he can use options profitably.  But he wants to take his time and be certain that he understands what to expect from any option investment that he makes.  He wants to be certain he grasps just how much he must risk to earn specific rewards.  I applaud this cautious approach.

Most option rookies fall between these extremes.  I know it's important to understand how options work before getting started and that's something I stress in my writings and coaching.  If you are reading this post, then you either have some interest in trading options or have already been trading, and are looking to further your options education.

To The New Trader/Investor (option rookie)

The remainder of this post is directed to the option-trader-to-be.  Let's discuss these questions:

  • What can options do for you? 
  • Why bother to use options? 
  • Are the stockbrokers who tell you options are too risky telling the truth?
  • Why don't financial planners use options?

After the stock market crash of October 1987, one of the common ideas [oversimplified in IMHO] was to blame 'options' for the stock market massacre.  The thought was that the huge number of outstanding naked puts resulted in a put buying panic by people who were forced to cover their positions.  Many of those put sellers went bust.  But consider the market makers (and others) who were selling puts to the panicky put buyers.  They had to sell stocks to hedge their own put sales.  Thus, the put panic resulted in a stock selling panic.  At least that's one of the unproven theories.

As a result, many brokers became cautious and chose not to encourage their clients to adopt any option strategy.  Why would they do that?  To prevent someone who lost money from suing.  Never mind that their customers were denied access to the risk-reducing properties that only options can bring to a stock market portfolio; these brokers were out to protect themselves.  No surprise, as this practice continues to this day.  But the bottom line is that some brokers still discourage options from being used, telling customers that they are 'too risky.'  The truth is that too many brokers have no idea how options work, and rather than appear ignorant, they avoid the topic.

Financial planners are not required to learn about options, and that makes it easy for them to simply ignore options and tell any client who expresses an interest in options whatever is necessary to make the client lose interest.

So, if you choose to enter the options universe, what can you expect?  How can options help you?

1) If you are a speculator, and if you believe you have a proven track record of knowing which stocks are moving higher and which lower, and if your ability includes the ability to time those moves, then buying puts and calls can work for you.  When you buy options the more volatile the market, the more you  must pay for your options.  But that volatility provides the chance for huge profits. I believe that most option buyers have little chance of succeeding, but if you have the skills, options provide leverage.  That means you can control many dollars worth of stock with an investment of a much smaller sum.  It's also possible to hit the jackpot on occasion and turn a small investment into a very good-sized profit.  But that doesn't happen often.  To me, option buyers are gamblers – but let's face reality. Put buying has been very profitable lately ( after all, the Industrial Average has declined from more than 14,000 to 6600, as I write this).  Any strategy works at least part of the time.

2) If you want to protect the value of your investment portfolio, options offer the ability to 'insure' that portfolio, just as you insure the value of your home or car.

3) If you want to make bullish or bearish investments, options offers a much better method for doing that than the traditional method of buying stock, or selling stock short.  Options provide limited risk strategies with the ability to earn substantial returns on your investment.  You can adopt any of several methods that provide limited risk.  You can find a strategy that feels comfortable to use.

4) If you want the possibility of earning profits when you have no idea whether the market is heading higher or lower, you can adopt suitable strategies.  You can play for a large move (in either direction) by buying puts and calls, or you can profit, with limited risk, from a more neutral market when specific stocks or indexes trade within a pe-deterined range over a period of time. 

5) Options truly are versatile investment tools and if you take the time to learn about options, you can find strategies that suit any type of investment philosophy – from wildly speculative to extremely conservative.  From bullish to bearish to market neutral.

One final word: You can find a way to use options that suits your comfort zone and your pocketbook.  But more than anything else – more important than choosing a good strategy – more important than your ability (or lack thereof) to correctly predict market direction, is risk management.  If you take care of risk and if you never allow large losses to occur and overwhelm profits, your chances of long-term success as an option trader are significantly higher than if you gamble and ignore risk.

2 Responses to Trading Options: What Are You Trying to Accomplish?

  1. Russ Abbott 03/06/2009 at 9:49 PM #

    This may sound strange, or one may wonder why I am saying this, but it strikes me that you are probably one of the nicest people in this area. Most people are motivated by money, ego, or both. And I’m sure you too are interested in fame and fortune. But I also get the sense that you care that people do well and that they not be cheated. That’s a very nice quality.
    On another topic: the other day I asked you about indices and index options. You pointed me to the CBOE website for indices. I noticed that they now list week-long options. Even though they’ve apparently been around for 3 1/2 years, I had never heard of them. Since you like to exit your trades a month before expiration, I assume you aren’t interested in them. But do you have any thoughts/advice about them? One advantage, of course, is that when selling weekly options, one gets the benefit of the fastest period of time decay.

  2. Mark Wolfinger 03/06/2009 at 10:06 PM #

    Thanks Russ. Yes, I care.
    I took a quick look at one week index options when they were first listed for trading. The markets were so wide that trading them was next to impossible.
    I suppose if you want to BUY options, these may be viable to trade. But there were zero spread possibilities that suited my comfort zone. I’ve never taken the time to look at them again.