For anyone trading options for the first time, the basic strategy of buying calls or puts is the first level allowed by brokerage firms. But there are a few things you should know about this basic strategy. It isn’t as straightforward -- or low-risk -- as it might appear.
Some important points to keep in mind:
1. Risk is limited … to 100%. Buying options allows you to control 100 shares of stock for each contract purchased. The good news is that you can never lose more than what you pay for the option, even though it gives you control over 100 shares. The bad news is that if you lose, it is a 100% loss. This is a clue that you should limit the dollar value of option speculation.
2. Most options expire worthless. About three out of every four options expires worthless. That means it’s about the same risk as betting on a 4-to-1 horse. You are likely to lose your cash 75% of the time.
3. Time is the enemy. Time decay reduces your premium costs, and this accelerates in the last two months of the option’s life. So if you pay three points in time value and the stock rises three points above the option’s strike, you end up only at breakeven.
4. Buying options is the first strategy you are allowed to undertake, but it is also one of the highest-risk strategies. For example, writing covered calls is a very conservative strategy but only more experienced options traders are allowed to do this trade. Why? Because shorting options is more sophisticated and advanced, and demands greater knowledge.
5. You have to remember the rules of automatic exercise. If you let expiration day pass by and your option is in the money, it will be exercised automatically. You might think you are going to let the option just expire because you have lost most of your money, only to discover that your broker exercised your position. In other words, know how the trading rules work and avoid unpleasant and unexpected surprises.
6. The basic strategy is usually thought of solely as a speculative move or as part of a rudimentary swing trading strategy. But there are many other reasons to buy options, including using puts to insure paper profits, setting up a contingent stock purchase or sale in later months, or exploiting momentary big changes in market prices. It pays to know about all of the possible strategies before simply jumping in and putting money at risk.
7. The dollar amount you use to speculate in options should be very limited. Buying rich options makes it very difficult to create a profit and, in the event of a loss, those cheaper options create far less in net losses. Keep a clear view of potential profits and potential losses.
With option speculation, as with any trading strategy, it makes sense to have more knowledge and experience than you might need just to execute a trade. You cannot expect 100% success, but beating 50% is going to put your trading experience in the winning column.