Five Things to Know About Options Before You Start Trading Them

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Five Things to Know About Options Before You Start Trading Them
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Rance Masheck, President and Founder of iVest+, a next generation stock and options trading platform, has been trading options for decades, but he knows that for many people they seem scary and high-risk. Like anything in life, something can seem scary until you understand it. Learning how options actually work and how to apply them correctly based on your goals takes away that fear.

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Things To Know About Trading Options

If you want to get started with options, Rance has five things that can get you on track.

Writing Covered Calls Is Not Always A Path To Success

A commonly taught approach to options is writing covered calls against a stock you own. This enables you to take the income of the premium of an option without selling the stock. Typically, you would do this when there is a great deal of premium on the option or if you truly believe the stock is about to pull back, but you don’t want to sell it. Maybe you’re at a gain on the stock and don’t want to lock in that gain for tax purposes.

While there is a place and time for this strategy, it offers no downside protection. If the stock drops, you keep the premium of the options, but you still have all the risk of owning the stock. If the stock rises, you will lock in your gain at the strike price of the calls you wrote, plus the premium you took in, thus potentially missing on upside opportunities. So the net result of the strategy is your downside still exists to the point that the stock can go down substantially, even to zero, and your upside is capped off. Successful trading over time requires the opposite.

Buying Out-Of-The-money Options Is Unlikely To Work

People like the idea of buying cheap options in the hope a stock will rise and make them a small fortune. Obviously, if you can purchase an out-of-the-money call and the stock blasts off, you could make a lot of money. Let’s say a stock is sitting at $44, and you can buy a call option with a $50 strike price with almost two months until it expires for $0.50 each. If the stock gets to $60, those $0.50 calls will be worth $10 at expiration.

But this is a high-risk way to play. Most options expire worthless. And calls that start completely out of the money are more likely to have no value at expiration because the stock has to overcome just the amount that it is out of the money to start to have an inherent value. It’s always great when something like this works. But the reality is it’s not typically a profitable strategy over time.

Multileg spreads can increase returns and limit risks versus trading stocks.

Multileg options are complex when you first look at them. There’s math involved in understanding what it means to buy one call and sell another, or to buy a call and put at the same time. But each of these strategies is designed to limit your risk while making you money if a stock moves a certain direction or holds essentially in place, depending on the combination of legs you look at.

But you can establish them in a way that your risk is limited and your profit potential is known upfront, even when trading an expensive stock. I encourage everyone interested in the markets to take the time to learn the various multileg options strategies. It is usually an eye-opening experience that changes the way people look at investing forever.

Be On The Right Side Of Time Decay

Every option has some amount of time premium. That means that what you pay for the option is more than what you pay for the option minus the difference between the stock price and the strike price. This can be because you purchased an out-of-the-money option contract or you bought something with a strike price near the current price of a highly volatile stock.

The time premium will decline to zero by expiration. That means that during the course of the trade, you will be fighting against time decay. When there is a lot of premium in a shorter-term option, the easier money to make is often by selling the option. This is why many multileg strategies rely on buying an in-the-money option (with little time premium) to control the underlying stock and then selling an at-the-money or out-of-the-money option to take in the premium and bank on making that time decay.

Understanding Implied Volatility Is Crucial

The most vital thing people typically don’t understand about options when they start is implied volatility (IV). Good trading platforms provide an indicator of implied volatility. By analyzing the pricing of an entire options chain, implied volatility shows you what is expected over the life of the option at the current time. When IV is high, the options have a lot of extra premium in their pricing, which means you are paying up for the options and have more time decay to fight against. When IV is low, the opposite is true.

Successful options traders understand how to use this calculation. When IV is high, the money is more easily made selling the options and bringing in the premium. When IV is low, you are more likely to find chances to buy options that have small premiums and use them to make money.

All the above takes time to learn, digest and implement on a regular basis. Whenever Rance talks to someone who is interested in learning about options, he says that he always wish he could jump them to a point where they understand these five key concepts. A lot of people treat options like a gambling tool because they don’t know any better. But the options market is built to help you control risk, and once you understand how it works, it can be a great vehicle for investing.

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