Trying different strategies before deploying them in real time
Options are different from stocks both in terms of what they represent – leverage, rights, and obligations instead of partial ownership of a company – and how they’re created, by demand. These important distinctions result in the need for additional trading and decision-making beyond the basic buy or sell considerations. Part of the learning process, as you transition from direct stock trading to options trading, is developing a new and complementary way of thinking. That includes not just evaluating the price of a stock or an index, but also how the price of the underlying asset along with other factors, such as supply and demand for the option and overall market conditions involved in options prices all come together. Your final decision, as the trade develops, may be to exercise your rights under the contract or simply exit the position in the market. Fortunately, market prices will help you with those decisions, and so will some thoughts from Chapters 9 and 18.
If you haven’t traded options in the past, your best approach (as we already mentioned) is to try out some trading strategies on paper and see how things work out. Your goal here is simple: You want to get to the point where you think of your option trades based not just on the option but on the underlying security.
Before you invest real money, you should be able to do the following:
✔ Gain a comfortable feel for the activity and characteristics of underlying stocks or indexes on which you are looking to trade options and understand their relationship both to the market and to the options related to them.
✔ To be able to mix and match sound strategies to particular market situations while keeping the preceding principles in mind.
Are these extra complications worth it? For many people, the answer is yes – especially when you consider the combined risk reduction and profit potential those options trading offers. And even though making the transition may sound difficult, the actual differences in stock and option mechanics are pretty straightforward and manageable. At the end of the day, the big advantage to options is the way they provide you with leverage while giving you a mechanism to control the rights to the stock rather than the stock itself.
An important aspect of this mental reshaping exercise involves paying special attention to how the real market action affects the value of options over time. Once you get this part of the puzzle locked in, the rest will fall into place more easily, and your paper trading will be more satisfying. Along with paper trading, you can also backtest options trading. And don’t worry about how long this learning process may take. Any time spent on decreasing your risk of big losses in the future is well spent.
Noodling out where options will work for your trading
There is a time and a place for everything. And options are used best when deployed optimally – meaning when the risk reward ratio offers you the best mix of both profit potential as well as risk reduction.
When you buy an option contract, you have two choices: You can exercise your rights, or you can trade your rights away based on current market conditions and your trading objectives. You can do either one based on what is happening in the markets or to any individual position at the particular time and by executing the best strategy for what the situation calls for. The most important thing is that you know what your choices are before making the trade because you have planned for either situation.
You can use options to reduce your risk by hedging a particular position or by hedging your whole portfolio. If your analysis of the situation makes you so bearish that you are looking to capitalize from a falling market, options are a much less expensive and uncomplicated way of selling individual stocks short. Chapter 10 is all about portfolio protection.
Options also let you leverage your positions. Because options cost less than stocks, you can participate in a market for less than if you owned the actual shares. This is an excellent way to reduce risk, as you are spending less capital but potentially getting a similar rate of return to what you might receive if you owned the actual underlying stock, depending on your position size. You can apply this leverage even more astutely if you are speculating and are willing to cap your profits.
This book is mostly about options on individual stocks. But index options are also an important part of the market, which may be of interest and use to you at some point in your trading life. The most important fact at this point is to understand the major differences between options on indexes and individual stocks. Here are some important general facts:
✔ You can trade stocks but you can’t trade indexes.
✔ The dates for exercise (of your option rights) and the last trading date for the option are the same for individual stocks, meaning that they fall on the same date. These two important dates can be variable for index stocks, meaning that you may be able to trade the option on a different day than the exercise date.
✔ There are two types of options: American and European style. Each has its own particular set of characteristics that will affect your ability to make decisions about exercise. Always know which style option you are using and the particular factors associated with it before you trade. Chapter 9 is all about option styles.
Using options to limit your risk
Getting the details of option risk profiles is important and will be useful. But actually devising and using strategies in trading is even better. You start by evaluating the many options that are available for asset protection. And although, you may not think that is sexy, spending the time up front to figure out what options work better than others in different situations isn’t only a good step in your learning process, it’s also practical. When using options to limit your risk:
✔ You can reduce risk for an existing position partially or fully and adjust the hedging process gradually based on changing market conditions. See Chapter 10.
✔ You can reduce risk for a new position to a very small amount by using a combination of options or by using single long-term options. See Chapter 12.
You will need a margin account for these strategies, and you can get one by filling out and signing the margin account agreement that you obtain from your broker. These are complex strategies that you can work toward as you gain experience. Some of these more complex strategies include
✔ Vertical debit spreads
✔ Vertical credit spreads
✔ Calendar spreads
✔ Diagonal spreads
The most influential factor on when to use these spreads will be market conditions. And this book will help you make those decisions.
Applying