Understanding Options Leverage - #1 - Option Trading Mistakes

Uploaded by tradeking on 02.12.2010

Hello, I'm Brian Overby, Senior Options Analyst at TradeKing. TradeKing is an online stock
and options broker. We're known for our award-winning customer service, cutting-edge tools, and
our competitive pricing - we're only $4.95 a trade. We also have a very active Trader
Network, which is a community of traders of all levels of experience where you can see
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Options Buying
Today we have a primer to all the education that is available on tradeking.com, and we're
going to talk about the top ten mistakes that option traders make. And I'm going to start
by options mistake number one: not understanding the leverage that's involved in options. To
get started, though, we have to ask ourselves: what
is an option?
And it's always important to understand that an option is a contract.
It's a contract that allows the buyer the right to buy the underlying asset at a fixed
price for a specific period of time, and it obligates the seller to take the opposite
of the trade if and when the right that is exercised in the body of the contract happens
by the buyer.
Now, what does this mean in the options world? You have four different things that you can
do with options. You can either buy a call, buy a put, or sell a call or sell a put. So,
if I buy a call, that means that I have the right to buy 100 shares of the underlying
- normally, 100 shares - and if I buy a put, I have a right to sell 100 shares of the underlying.
We're going to focus on the buying of options today. So, if I buy a call, that means I have
an intention of buying something at a later date; I usually want the marketplace to go
up. If I buy a put, that means I have an intention of selling something at a later date; that
usually means I want the marketplace to go down.
There are very simple, straightforward situations, but as far as puts are concerned, people get
a little more confused. Because when you buy, that means sell, so that's a little bit confusing,
in that I'm buying with the intention of selling something at a later date. If I buy a call,
I have the intention of buying something at a later date. They're pretty much straightforward.
What we really need to understand is that, if I buy a call, I want the marketplace to
go up, and if I buy a put, I want the marketplace to go down.
Now, let's talk a little bit about the outright buying of options. And I have a question for
you: is the outright buying of a call option, or even a put option, considered to be a speculative
or a conservative strategy? And I'd say that there's not a simple answer to that question.
The answer to the question really is that it depends, and I want to talk about this
We have two different people here, we have Peter and Linda, and Peter and Linda both
have about $6,000 in their account. And what they're looking to do is, they normally buy
100 shares of stock, but they find out about option trading so they're going out and they're
actually going to look at buying options, as opposed to buying the stock, because they're
bullish on the marketplace. Now, with $6,000, when stock was trading at around $60, we have
about $6,000 to buy 100 shares of stock. The commission at TradeKing would be $4.95 on
top of that, so keep that in mind. Whenever you trade, you've got to keep commissions
in mind.
But, Peter goes out and reads a book on options and says to himself, gee, if I look at this
one option contract that has a $60 strike on it, I see that that's trading for $3. With
that same $6,000, I could buy almost twenty contracts, if I don't think about commissions.
So, I look at that trade. If I was going to buy twenty contracts, I saw it trading for
$3, the way that I'd figure this out is, I'd take 20, multiply it by the number of shares
each contract represents, which is normally 100 shares, and then I would multiply it by
the quote, which is $3. So that means I'd be spending my $6,000, and don't forget, we'd
have to put the commission on it. At TradeKing, the commission would be about $17.95.
Now, on the other side of the coin, Linda also goes out and checks out the education
on the TradeKing site
, if you will, instead of reading the book flat out, and says, gee,
I'd like to buy 100 shares of stock also. But I've read about options, and I'd actually
like to use options more as a risk reducing strategy.
In other words, if I buy the stock, I have risk from $60 all the way down to $0, or,
I could lose my $6,000 that way. But if I buy the option contract, I have a right, not
an obligation, to buy it at $60, and I see this option contract is trading for $3. Basically,
they're looking at the same call option.
So, in this situation, if I spend that $3, and it represents 100 shares of stock, we
actually see that this option contract would cost us $300 plus commission, and the commission
would be about $5.60. The nice thing about this is that Linda can actually then take
the remainder of those dollars and deposit it in the money market, and actually earn
interest on those funds over the life of the trade.
If we look at both of these scenarios, the biggest thing that Peter needs to understand
is that, if you take all your money you were going to invest in that stock and you buy
as many contracts as you can, if, at the expiration of the option contract, the stock hasn't moved,
you may lose your entire investment. Or, if it goes down, you almost definitely lose your
entire investment.
On the other instance, if I go out and I just buy one call option - and I'm actually using
options more as a conservative strategy - in this situation, Linda is then using options
to kind of reduce risk, in that, yes, I do pay $3, but if the stock goes down, I don't
have to buy it at $60. And the most that I can risk in this position is $3, the monies
that I paid for the trade. If I'm thinking about trading options, I need to understand
the leverage that's involved with an option contract.
With that said, do you understand the leverage, that was the question. Here's the answer:
how do I trade smarter? Well, one general rule of thumb that I always talk about with
basic option traders that are just getting into the marketplace, coming from the stock
world is, if you're used to trading 100 shares of stock, buy one call option. If you're comfortable
trading 200 shares of stock, think about buying two call options. And when you do this, when
you're first starting out, don't go in and just try to take, well, this was the investment
capital I was going to use, I'm going to take all that and I'm going to invest it in the
options market. I've seen a ton of people do that, that first come in. Why? Because
they can. They have the monies in their account. Why not do that? I'm going to be right on
my trade anyways, is the thinking.
Now, if we look at this, I say start small. Learn how to trade in a smaller size. If you
are profitable in a smaller size, most likely you will be profitable in a larger size. So
take it slow. And when you're looking at the smaller size, look at your percentage gain
on the position. Don't go out and look at it on a dollar basis, because we?re trading
smaller contracts. Wow, I traded this option, my forecast was correct, I might be up 10,
I might be up 15, I might be up 20 percent. But look at that in your investing strategy,
as opposed to just looking at the small picture, and let yourself target="_blank">learn about option trading.
That was the first mistake that we've seen in the Top Ten Rules of Option Trading. If
you'd like to learn more about these topics, please check out our Center on tradeking.com. Also you can find answers to your questions inside our
Trader Network, where many traders like to share tips and talk about where the marketplace
is going to next.
I've also authored The Options Playbook, which available for purchase on amazon.com, and
you can actually view it online for free at target="_blank">OptionsPlaybook.com. If you'd like to hear more about my thoughts
and tips, check out my blog on our Trader Network - just look for the Options Guy.