Trading Options for Dummies: 7 Eye-Opening Things I wish I knew
Trading options for Dummies? This isn’t a best-selling article (at least not yet), but let’s take a look at how we arrived here. Years ago I decided to give options trading a try after viewing some videos on the subject and reading about investors who made double, triple, and even 1000% gains on Wall Street Bets, so naturally this piqued my interest. Having set up my emergency fund (here’s why you need to have an emergency fund) and prepared my TD investing account for Options trading, I was ready to go.
While I had seen some very attractive images of 1,000% gains, I had also seen screenshots of options traders losing 90% of their capital on a single bad move. This last possibility is what prevents many people from trying their hand at options trading.
Trading in options is high-risk, but it is also a potentially lucrative investment vehicle to wealth. It doesn’t take long for some people to multiply $500 by a factor of a hundred thousand, and by the same metric it doesn’t take long for others to go in the opposite direction and wipe out their account.
I was aware of the dangers involved, but that didn’t stop me from exploring my choices. Only by actually investing can you learn what works and what doesn’t, so I decided to test out options trading. Some of the things I’ve picked up along the journey are listed below.
Trading Options for Dummies: Key Things to Learn
You can do a lot with a Small Amount Of Money
Options make up 3-5% of my portfolio, but it wasn’t always this way. Anyone trading options for the first time should allocate no more than 1% of their portfolio to their preferred calls and puts.
If your options fail, it will only be 1% loss of your portfolio. In the long run, you won’t notice the drop. On any given market day, a 1% drop is possible and managable. A 10% drop in your portfolio would be more significant.
I use this mindset when trading options, but the appreciation of my options is the primary reason they now account for no more than 5% of my portfolio. The current calls I own have changed by 23%, -72%, 110%, -12%, and 75%. Not bad considering the state of the overall market
To see big returns, you don’t need calls and puts to be a big part of your portfolio. Making calls and puts at just 1% of your portfolio significantly limits your downside while providing massive upside potential.
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Supercharge your Dividend Investing
You can sell options in addition to buying them. By selling options, I can generate cash flow from my current positions. It’s a simple method to earn a few hundred dollars every month.
You should only sell covered calls and puts that are backed by cash. The other options are very dangerous, notably unprotected calls, which have a limitless potential for loss.
You must possess 100 shares and agree to sell them at a predetermined price in order to execute a covered call. If the price of the shares never reaches that level, the option expires worthless, and you keep the premium.
You agree to purchase 100 shares at a specific strike price and are compensated for that commitment when you purchase a cash secured put. You keep the premium even though the put expires worthless if the stock doesn’t reach your strike price. Buffett frequently employs this approach to stock acquisition.
Your portfolio’s cash flow will improve if you sell options. You can purchase additional shares using the premium from your options in order to sell more options contracts in the future.
Longer Term Options are a Safer Option (pun intended)
The amount of risk-taking that was described in the gains and losses of Wall Street Bets made me shudder. I understand that sometimes taking high risks in exchange for high rewards is part of the game, but watching people purchase calls and puts that would expire the following day seemed scary.
An option becomes more cost-effective the closer it gets to expiration. But there is a big risk involved. If the short-term stock price movement goes against you, there is no time for recovery.
If you purchase an SPY call that expires the following day, and the S&P 500 opens that day 1% lower, you will probably lose 80% of your initial investment right away. Then, all you can do is hope that the S&P 500 recovers or sell your investment now at a loss before it loses all of its value.
This is the mental game of diamond hands vs. paper hands in options trading. Sometimes you’ll feel the urge to sell because you’re worried about sudden changes in price. Other times, you’ll commit for the long run—for good or bad.
Buy longer-term options that expire at least a month in advance rather than those that expire the same week. Although the premiums for these options are more expensive, they give your thesis more time to develop.
It is simpler to approach options trading as a long-term investor by purchasing options with expiration dates of a few months as opposed to a few days. This enables you to exercise patience with an option if you have faith in the long-term story surrounding a stock.
In comparison to buy and hold, options trading is more of a mental challenge. It is simpler to maintain mental calm when the expiration date is further away.
Options Trading is Better Than Buying Lottery Tickets or Gambling
Instead of purchasing lottery tickets, you should trade options. In order for someone to win the jackpot, millions of people must lose their lottery tickets, which are rigged against you. Perhaps you’ve heard the joke that your chances of winning the lottery are higher than those of being struck by lightning or killed by a vending machine.
The likelihood of you succeeding with your calls and puts is significantly higher than the likelihood of any of those outcomes, especially winning the lottery. Those who wager on the lottery have no qualms about losing their money.
You will undoubtedly feel as though you wasted your money if an option drops to zero dollars, but as you learn to recognize opportunities and improve, you may be able to ride one of your investments to a 1,000% return.
If buying lottery tickets is your version of options trading, it is also much better than going to the casino. To find opportunities, you can conduct thorough research, make investments based on your risk tolerance, and make adjustments as you go. Option trading gives you far more control than gambling or the lottery ever could.
Don’t Get Overconfident
To me, it’s preferable for an investor to lose money on their first options trade than to gain it. The ideal option would be one whose value increased by 50% at first and dropped by 30% by the time an options trader decided to sell.
You will become humbled by early defeats and be reminded that you are not always right. Early successes may give you the impression that you have the magic touch, leading you to take on excessive risk.
It’s okay to rejoice when you succeed, but keep in mind that you won’t win every time. By adopting this mindset, you can avoid investing in options with the expectation that you will always succeed. You will be putting your portfolio in danger if you invest 10% of your total portfolio in a single call option.
Investments in options trading have a high risk-to-reward ratio. Avoid being deterred by the risks, but also avoid becoming indifferent to them.
Focus on Managing Risk and not on Profit
Instead of concentrating on increasing your profits, try to reduce your losses. Why should we focus more on profit after we enter a trade when we already believe it will result in some profit before we enter it?
Only after you have performed your profit calculations do you engage in a trade. Your focus after entering the trade should be on minimizing the loss (if it occurs).
Trading goes against both human nature and behavior.
The truth is that nobody can be completely correct when trading. You will therefore make mistakes from time to time, and the goal is to minimize your losses.
Instead of holding onto unrealistic expectations, you should quickly close the trade out to reduce your losses. Even though it’s extremely uncomfortable, it’s always the right move.
According to a concept known as the risk-reward ratio, if your risk is x, then your profit should at least be x2. Trading professionals aim for 1:3 and higher, but novices should stick to 1:2.
Don’t pressure yourself to immediately recover your losses
When I first started trading, I used to believe that if I lost money in the morning, I had to make it up that day. We lose patience and discipline as novice traders when we trade with the intention of recovering our losses.
Our own trading policies are broken, which is disastrous. The market is constantly watching for you to violate your own trading guidelines, and once you do, it will quickly wipe out your account.
Market reopening is planned! With improved attitude, tolerance, and discipline, you can trade the following day.
For those who are just starting out, there is a rule known as the “2 Stoploss a Day” rule, which states that you should close your trading setup and leave the market if you experience 2 stop losses in one trading day. You’ll inevitably make bad choices if you don’t, which will result in further losses.
Is there anything you owe the market when you make a profit? No!
The market also owes you nothing when you lose money.
Only the money you lose is owed to you; the profit you make is entirely your own doing.
So bear this in mind when you lose:
First of all, you don’t have to get it back that day.
Furthermore, you are not required to get that money back from the market itself. To make up for the loss you suffered from the market, you could put time into one of your side jobs.
Do not also deposit your main source of income into your trading account. In the worst case, only allocate 10% of your primary monthly income to your trading account.
Mark This Down: The Bottom Line
People with money in the stock market acquire experience, while those with experience acquire money.
When we view wealthy day traders online, there are things that we miss. Trading is not gambling, except when done intentionally.
It’s just another profession where success depends on your ability to learn, grow, and maintain discipline. Do your best to replicate winning habits, and learn from your losses.
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