Options Advice

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Options: A Foolish Introduction

This investment vehicle doesn’t have to be confusing.

Historically, The Motley Fool has shied away from options as an investment vehicle, for reasons best stated by people smarter than we. Peter Lynch, a Foolish favorite around here, was not a fan of small individual investors using options. And we’re ever mindful of Warren Buffett’s first rule: “Don’t lose money.” Options, by their very nature, can significantly amplify losses. Then again, as leveraging instruments, they can also amplify gains.

Options have enjoyed a much higher profile in recent years, as trading volumes increased, curious investors dipped their toes into untested waters, and new specialized brokers entered the market. Late-night infomercials feature alluring red-and-green-flashing software and testimonials from ordinary people who, with little to no training, claim to have made fortunes in the option markets.

That last point is why we’re here. This series is not intended for traders or sophisticated professionals employing complex arbitrage strategies or looking to trade volatility. Instead, we’re hoping to give ordinary Fools a firm knowledge of what options are, and how we recommend using them in hopes of improving returns.

Image source: Getty Images.

Options are something else

The best place to start would be to define exactly what options are. Options are derivatives — they derive their value from an underlying “something else.” Before you start using options, it’s Foolish to make sure you understand exactly what that “something” is.

For years, Warren Buffett has warned investors about the potential dire consequences of unchecked and growing derivatives use in capital markets. Then again, the Oracle of Omaha himself has used derivatives when he feels the market’s offering him a value opportunity. So we can understand why Fools might be confused by this seemingly contradictory behavior.

To state this emphatically, we Fools believe that 99% of individual retail investors — that’s you, folks — can happily go through life without ever buying or selling an option. But derivatives themselves (of which options are only one part) aren’t inherently bad. The real problems stem from their wide proliferation, and the crazy accounting with which they’re associated.

Options are just tools, and they’re only as good as the people using them. Shrewd use by well-educated investors can greatly enhance a portfolio’s returns. Reckless, ill-informed use of options, however, can badly damage your holdings. To use options well, you’ve got to have a healthy understanding of the intrinsic value of the business involved. Without that most Foolish of principles, how safe do you feel in using options to leverage returns?

A few Foolish caveats

You won’t find descriptions here of option trading for trading’s sake. If you’re interested in day trading or “black box” software, look elsewhere. Most of those programs should come with warning labels, and some should be illegal.

Don’t look here for an option-only trading approach, either. We believe that options derive their value from real businesses, whose real worth can be estimated and employed as a sturdy foundation for a Foolish options strategy.

Many people, including plenty of folks in our Foolish community, have done very well by treating options as trading instruments. If you’d like to try to follow in their footsteps, we’ll point you toward some resources that might help. For the rest of you, sit back and relax. If you finish this series with a better understanding of the mechanics, risks, and potential rewards of options, we’ll have done our job.

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  • Binomo
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And, for those of us who are already familiar with the fundamentals of the options world, check out these more intermediate-level how-tos:

Options for any market

Discover the strategies used by the pros to make money no matter what the market does. Master the theory behind time-tested techniques via straightforward video lessons and apply them to your own trading in no time.

Strategies for a COVID-19 Market?

Conventional option trading will teach that it is best to sell options when volatility is high and buy when volatility is low. And at the moment volatility has spiked, meaning option premiums are higher than normal. There are many ways to sell option premium, but a favourite of mine is the Iron Condor.

I sold the $281/$282 & $203/$202 Iron Condor on the 27th March for a $30 credit per contract. Expiry date is 17th April, 2020.

The maximum I can lose on this trade is $70 per contract but I have a 28% profitability band. I.e. the SPY needs to stay between 14% either side of the current price. Those levels are 281.30 on the upside and 202.70 on the downside.

I followed the same trade setup criteria as taught in the Module 3: Trade Selection and Strategy (SPY) inside the members area.

Update: 3rd April, 2020

SPY closed at 248.19 on Friday, which is right in the middle of my breakeven bands. The closing price of the option combination was -0.10 or $10 credit. If I were to exit the trade now I will make $20 per contract, which is 29% return on margin. There is still two weeks to go though until expiration, but so far so good.

Top 10 Option Trading Tips

Option Trading Tip #1

My top 10 call and put option trading tips that I have learned, and that you MUST know before you start trading calls and puts.

Trading Options Tip #1:

A stock price can move in 3 directions:

  • It can go up
  • it can go down, and
  • it can stay the same.

Most beginning option traders think that stock prices will either go up or go down, but they would be wrong! There is a third direction that stock prices move that is extremely important for call and put traders. Option traders must remember that that sometimes stock prices don’t move up or down at all and that they can stay the same or remain in a narrow trading range.

Look at the chart below and you will see that for the last 23 days this stock’s price remained mostly unchanged. Had you bought call options (expecting a bounce) or put options (expecting the continued decline) you probably would have lost your money!

So don’t think you have a 50% chance of making a profit when you buy a call or a put option. It’s more like 33%. That’s because if stock price movements are random you will find that 1/3 of the time the stock price goes down, 1/3 of the time the stock price goes up, and 1/3 of the time the stock price remain flat or stays almost unchanged. In fact, when you are long a call or put option, time is your worst enemy. Each day that goes by your option is losing value since the chance that the stock price will move in the direction you want it to move is diminishing.

When you buy a call option, you are betting the stock price will go up. Sometimes the price will go up and you will have a profitable trade. But sometimes the price goes down, and sometimes the price just stays the same. If the price goes down or just stays the same and you bought an out-of-the-money call, then your option will expire worthless and you lose all of your money. If the price just stays the same and you bought an in-the-money call, then you will at least get your intrinsic value (or your in-the-money amount) back.

Sometimes the most frustrating thing about buying call call option is watching the stock price sky rocket the week after your option expired. In this case you will learn that you didn’t give your strategy enough time. I have bought many call options that expire in the current month, only to see my stock stay flat and then rocket up AFTER my call option expired. That’s the risk that you take buying a near month option and not a longer term option. That’s also the reason the longer the term of the option the more costly the option will be.

Because of this concept that stock prices move in 3 directions, it supports the general claim that 70% of option traders that are long call and put options lose money. This means that 70% of option sellers make money. This is what drives a lot of the more conservative option traders from the strategy of buying call and put options to selling or writing covered calls and puts. Keep reading my next tip that you must study a stock’s chart before buying call or put options.

Here are the top 10 option concepts you should understand before making your first real trade:

Best Binary Options Brokers 2020:
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    Binarium

    Top Binary Options Broker 2020!
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  • Binomo
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