With more volatility in the market and with online brokerage firms such as TD Ameritrade, Robinhood, etc. offering low/zero commissions, interest in options and options trading has exploded! Novice options traders are looking for ways to distinguish between the actual risks and the option trading myths.
In fact, according to Bloomberg, TD Ameritrade reported an all-time last high in April for its “Education Center,” up 280% from the prior year with the most popular classes including options trading (The Chicago Board Options Exchange offers a variety of free and paid educational resources as should your broker).
Also, online message boards have similarly seen a surge in their options trading room members and communications as new traders have raced to find new ways to make money.
Because of this exploding interest in options and options trading, I wanted to share some of my options education for those interested in learning more about options, but who were scared off by some of the following common options trading myths.
Option Trading Myth 1: Options Trading is too Risky.
This is definitely the most pernicious options trading myth. It is true that options are risky if you don’t know what you’re doing. But with a little education on the subject, options trading can be as safe as you want it to be. When done right, the whole point of options is to reduce risk.
Options are all about probabilities, which enable you to choose your level of risk in a trade. For example, if you want to play it safe and hit “singles”—i.e., go for modest returns that eventually add up if you string enough of them together—you can choose a trade that has an 80% probability of success. For instance, selling covered calls on highly rated stocks can generate additional returns on investments you already like.
If you’re willing to take on more risk by going for home runs even if it increases the chance that you’ll swing and miss, you can reduce your probability of success in exchange for a much bigger payoff.
So really, the options trading myth that it’s risky is only part myth. Options trading can be risky … but only for the uninitiated. Which brings me to myth No. 2 …
Option Trading Myth 2: Options Trading is too Confusing.
It’s true that trading options is more complex than buying and selling stocks. Options comes with its own vernacular—covered calls, selling puts, the strike price, iron condors, etc.—and that requires some getting used to. But it’s not like learning how to split the atom. Like most things, options can be learned easily if you’re willing to put in just a little bit of time.
Once learned, the options-trading process will quickly become second nature. You don’t have to be a seasoned professional to trade options. There are plenty of self-directed investors who picked it up and now trade options regularly. You can too.
Option Trading Myth 3: You Need a lot of Money to Trade Options.
Not really. For most trades, you don’t need more than $1,000 in capital. And why is this? Because the most powerful factor of options is the leverage you get when buying calls and puts. For example, instead of paying $5,000 to buy 100 shares of stock XYZ, with options you can pay $200, and have the same upside potential as if you had bought the stock.
If possible, you should plan on allocating between 2% and 5% to each trade. By not risking too much on any one trade, and with the awesome potential of the leverage that options allows, you should theoretically get more mileage—and hopefully more profits—from your options money than you would if you invested that money in 10 stocks.
Option Trading Myth 4: Options Require a Bull Market.
Not necessarily. Through the magic of puts, you can still profit even when the market begins to fall. In traditional investing, the average investor can’t outright short the market by selling stocks or indexes short because of the unlimited upside risk. However, puts allow options traders to gain bearish exposure at a fraction of the cost. A put purchase is used when a decline in the price of the underlying stock or ETF is expected.
For example, if you expect stock XYZ to fall, you could buy a put at a specific strike price with unlimited potential for profits. The maximum loss on the trade is the amount of premium paid.
For example, the purchase of the XYZ 100 put for $1 would only risk the $1 paid. If the stock were to close at $100 or above at expiration, the put would expire worthless, and your loss would be limited to the $1. However, if the stock were to go below $99, the holder of this put would make $100 per contract purchased per point below $99. By purchasing puts, you can take advantage of a down market with low-risk, high-reward trades.
Option Trading Myth 5: You Can only Trade Options on Stocks You already Own.
Wrong. The beauty of options trading is that you’re not limited to the stocks already in your portfolio. An option is a contract that conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day).
The advantage of trading options is that, unlike buying stocks, you can define your risk ahead of time.
When you buy an individual stock, you put a relatively large chunk of capital to work, which exposes you to the occasional bombshell, whether it’s a bad earnings report, a big drop in the market or a random company-specific event that brings out the sellers.
Options, on the other hand, give you the opportunity to get exposure with limited capital. If you know what you’re doing, you can make trades that have a 60%, 70% or even 80% probability of success. And options allow you to be more aggressive too—you can take on more risk to potentially earn a bigger return.
And your risks are clearly defined ahead of time in a way that’s impossible to duplicate through pure stock trading.
*This post has been updated from an original version.