Are Options risky? Most investors would say absolutely.
Novice traders often don’t take the time to learn the right way to use options. They jump right in thinking “I got this.” They gamble, blow up their accounts, and then walk away penniless and swearing off options forever.
Even experienced traders sometimes get caught up in the allure of fast gains. They overleverage their positions—take a bigger position size than they should—and then take a hit. All the options traders I know, including myself, have blown up their accounts at least once.
Most people use options the wrong way. Most people use options to increase leverage… to get more “bang for their buck.” In other words, most people use options to increase risk.
This is wrong and is not the intent of options. When used correctly they LOWER RISK....
Options allow you to risk much less and profit just as much as you would buying stocks.
Let’s say you want to buy stock in Company X. It trades for $10 a share. You could put up $1,000 to buy 100 shares… But you can control the same amount of stock with one option contract. You can buy a contract for, let’s say, $50… and leave the other $950 in your account.
If Company X’s stock goes up, you’ll make money. If the stock goes down, the most you’ll ever lose is that $50. That’s a 100% loss… but it’s a lot less than potentially losing 20% or more of the $1,000 you would risk if you bought the stock.
This is a simple example. And it’s the simplicity that proves my point. Options allow you to risk much less and profit just as much as you would buying stocks.
But that benefit disappears if you over leverage the trade and take on a larger position with options than you would otherwise take with the stock.
That’s the biggest mistake most novice options traders make. Instead of replacing a 100-share purchase with one call option (an option that gives you the right—but not the obligation—to buy or sell a particular stock at an agreed-upon price at a set time in the future), they take the entire amount they would have allocated to the stock and buy a much larger position with the options.
Rather than buying one call option for $50 and leaving the remaining $950 in the bank, novice traders take the entire $1,000 and put it into buying more call options.
They end up buying 20 call options to try to get more bang for their buck. What would have been a 100-share purchase has turned into control of 2,000 shares. Instead of using options to reduce risk, they’ve increased their risk 20 times.
Losing 100% on an overleveraged trade would be a disaster. And it’s why most folks think options trading is dangerous. But it’s not dangerous if you trade options the way they were originally intended… as a way to reduce risk.
Happy trading Steemians