One of the biggest and least understood tricks about trading for a living is to minimize the downside as much as possible and to squeeze every last drop out of the upside. Why is this so critical? Because of this simple truth:
You will lose sometimes. Even at the top of your game, you can expect to lose about half of the time. But while those losses are small and controlled, the upside has no limits. That way you still come out with a profit.
I’ll let you do the math: ten trades made, five of them with a 50% gain, five of them with a 20% loss. The end result is profit.
Options can be used to reduce the downside even more.
If you buy a call option instead of buying the stock outright (as most people would do), you will reduce the downside and maximize the upside. Here’s how…
XYZ is trading at $21 a share.
You buy stock XYZ June $22 call options for $0.50.
In other words, you paid $0.50 per share for the right to buy XYZ at $22 per share (the “strike price”) by option expiration in June.
Unfortunately, this turns out to be a loser. By June expiration, the stock is below $16. You’re not going to pay $22 for a stock trading at $16. The XYZ June $22 call options expired worthless, and you lost 100% of the money invested in that position. But losing $0.50 on a call option is a lot better than losing $6 per share, which is what would have happened had you simply bought that stock. And people say trading options is risky!
Here’s another way to think about it… If you had bought 100 shares of stock, you would have committed $2,100 (100 shares at $21) to the trade. That money would be at risk and subject to loss.
Buying one call option contract also controls 100 shares. But the premium was only $50. So there was much less money at risk.
That’s the real benefit of trading with options… there’s far less risk than trading the stock.
Of course, that benefit disappears if you over-leverage the trade and take on a larger position with the 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, 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 (1 contract = 100 shares) and leaving the remaining $2,050 in the bank, novice traders take the entire $2,100 and put it into buying more call options.
He’ll end up buying 42 call options to try to get more bang for his buck. What would have been a 100-share purchase has turned into control of 4,200 shares. Instead of using options to reduce risk, he’s increased his risk 42 times.
As you can see, losing 100% on an over-leveraged 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.
Limit your option exposure to control just the number of shares you would normally purchase. Leave the rest of the money in the bank. Then it won’t be so bad to lose 100% on an option trade. It will almost always turn out better than what you could have lost on the stock.
And if the options trade goes well?
Let’s say XYZ goes to $28. You had the option to buy 100 shares at $22. $6 profit per share = $600 profit on a $50 investment (the price you paid for the option).
That’s a 1200% return.
Had you bought the shares instead, it would have looked like this:
$2100 with a $600 profit is a 28% profit.
Quite a difference!
Best,
Jim.
