You've heard it before.
'They're too risky.'
'They're too complicated.'
Yes, I'm talking about options. But before you stop reading this, hear me out. They don't have to be as risky and complicated as their reputation.
In fact, my colleague Amber Hestla has uncovered a way to use options safely and profitably -- bringing in as much as $150,000. She's made money on every single trade that she's done since she started her 'Income Trader' newsletter for our sister site, ProfitableTrading.com. Click here to learn more about her system and her 'perfect record.'
But the fact remains that options sometimes have a bad reputation. They can be daunting for beginners and trading them is fast-paced.
This doesn't mean that you can't become a skilled options trader like Amber, however. Once you understand the basics, you'll find that it's fairly straightforward. With some practice, you can soon find solid success with your options trading strategy.
As you start out, here are five things you need to know about trading options:
1. Think In Terms Of Fixed Percentages, Not Dollar Amounts.
When starting out, it's important to properly manage your risk. However, many options traders don't fully understand this. They think of making trades strictly in dollar amounts. You might have an account of $5,000 and decide that you want to make $2 for every $1 that you risk. Of course, this means that you have $2 on the line (potential loss) for each $1 risked as well.
If you decide that this works by putting $500 on the line for each trade (buying a number of options), you could quickly run out of money. It would only take 10 bad trades to reduce your account to nothing. However, using a fixed percentage changes things up a bit. If you decide that you are willing to risk 3% of your capital per trade, that means that you are only putting up $150 per trade. However, you have a little more leeway. And, as your account grows, the amount you risk grows in line with the fixed percentage you are willing to risk.
2. Forget About 'All-Purpose' Strategies -- Let The Market Guide You.
For buy and hold investors, particular those who invest in dividend aristocrats or index funds, there is one strategy employed, no matter the market conditions. Keep investing and don't sell unless something changes radically in terms of fundamentals.
There is no such all-purpose strategy for trading options. You need to change your strategy as market conditions change. Look for opportunities to buy calls, puts and spreads, depending on what's happening in the markets.
3. Protect Yourself By Hedging.
An important part of options trading is hedging. This is when you purchase an opposing position at the same time you make your main position. If you think that a stock is going to head higher, you could buy 10 call options. But what if the stock doesn't break higher? You lose that money as the options expire worthless. Instead, you can hedge by purchasing five put options at the same time. That way, if the trade goes against you, you limit some of your losses. If it really goes against you, your put options might even result in profit.
Another hedging technique is a covered call. With this strategy, you sell a call on a stock you own. That way, you agree to cover sell the stock at the strike price in the option. Instead of the capital risk being entirely on the option, it is, instead, in the asset.
4. Develop An Exit Strategy Now.
Have an exit strategy for when you are winning as well as when you are losing. A good exit strategy can help you limit your options trading losses when things go against you. Your exit strategy when you are ahead can ensure that you take profits now, rather than risk losing them later.
5. Resist The Temptation To Double Down.
It's tempting to make up for losses by doubling down. This can only cause a bigger problem if the trade is going against you. Another difficulty is not doubling up when you are ahead of the game. It's tempting to run your profits, adding more to a position, just to try and take advantage of what seems like a solid trend.
You need to be careful though. Increase those positions in the hopes of playing catch up -- or even getting really far ahead -- can be devastating if things suddenly turn the other way.
The Investing Answer: It's fairly easy to open an options trading account. Many online discount brokers offer options trading. Start small while you learn the ropes, and gradually increase your trades as you improve. Over time, it's possible to make a tidy living by trading options.