It’s a pervasive myth about options that they are complicated and risky. The reality, however, is that options are nothing more than a vehicle to gain exposure to stocks in different ways. You see, it’s very easy to categorize options as difficult to understand, but knowing just a few basic characteristics about options makes them very useful and easy to understand. Anyone—meaning absolutely anyone—can learn how to confidently trade options.
Tip 1: Options Should Really Be Thought of As an Extension of Stocks
As a trader, have you ever been in a position where you weren’t sure if you should be holding a stock or letting it go? Anyone who has traded before has surely been faced with that question and oftentimes, having options at your disposal allows for much-needed flexibility when your investment has faced setbacks.
With stock trading alone, you are limited to initiating bullish exposure by buying shares and bearish exposure by shorting shares. Your avenue to a winning trade lies in your ability to correctly guess the direction of the stock, whereas with options, you can bet long or short with less overall risk and lower capital outlay. These added benefits are just a tiny fraction of what’s available when trading options. But the main takeaway here is that options are nothing more than extra options traders have in their toolbox to express an investment idea.
Tip 2: Options Can Put the Odds in Your Favor
Believe it or not, trading options can allow you to put the odds in your favor, meaning you can place trades where you have better than a 50% probability of being profitable. And these are not trades that add extra risk compared to stock trading alone. In fact, they can actually reduce your risk. These types of setups make options much more advantageous than trading stocks alone.
When you buy a stock, you need the stock to increase for you to profit. When you short sell a stock, you want the stock to go down for you to profit. Those two trades describe 50% outcomes—basically, no real edge. So imagine, you are bullish on a stock and now you have the ability to make money if the stock rises, stands still, or falls a small amount. This is where options can become crucial to a successful portfolio.
Most would agree that Warren Buffett puts the odds of success in his favor when he makes an investment decision. What you may not realize is that he is one of the largest users of options in the world. If used correctly, options allow you many opportunities that give you an edge in trading. And we all want to trade with an edge.
Tip 3: Fear and Greed Can Mean Big Profits for Options Traders
The adage to be “fearful when others are greedy, and greedy when others are fearful” can be used when finding profitable options trades. There are times when the outlook for a stock is extremely bleak and the risk-reward sets up nicely for the options trader. Often, trading against the consensus can skew the odds in your favor. We’ve all seen stocks bounce around on news reports, market noise, etc.—just to see the stock eventually revert back to its previous price. Being able to use options during events like these can offer attractive trade setups where greed and fear provide an opportunity to the savvy investor.
When these opportunities present themselves, it can be instructive to calculate the outcomes of all the possible scenarios from the get-go, and when things line up, it’s time to strike. Being ready to take advantage of market volatility is an asset the patient investor knows how to utilize. You won’t always be on the winning side of the trade, but if you continuously look for scenarios that put you the investor in the position most likely to benefit, you’ll come out ahead in the long run. Investing is a long game so shifting your focus away from being the “gambler” and into being “the house” will give you the advantage you need to succeed.
Tip 4: Options Can Enhance Portfolios Like No Other Tool Available
Enhancing a portfolio doesn't necessarily mean adding a lot more risk. Instead, it can simply mean using options to reduce risk and adding income to a portfolio, which isn’t possible with trading stocks alone. There are times when enhancement is warranted and times when it is not. The key is to be alert for the right setups that benefit your portfolio over the long run. Whether your goal is steady growth, income-oriented, or short-term in nature, if you are making the right bets with the odds in your favor, you’ll be positioned for success.
When making the decision to enhance your portfolio, the goal to really strive for is consistency. There are opportune times for an options trader when a portfolio gets extended, and there are advantageous times when a portfolio falls under pressure. Being able to identify those times with a clear head is paramount. Just like a car mechanic is only as good as their tools allow them to be, the options trader has to use the right tools at the right time to enhance a portfolio.
There are effective enhancement strategies available to any level of options trader, especially beginners. Options trades rarely have to be complex to make an impact on a portfolio. (We review the favored strategies in the Options for Beginners course at Investopedia Academy.)
Tip 5: Patience Is the Options Trader’s Route to Profit
There are good trades, bad trades, winning trades, and losing trades. There will be good trades that turn out to lose (and that’s okay), and there will be bad trades that turn out to win. The key is to realize that the highest likelihood of success lies in making good, solid, sound trades.
One area where stock traders and options traders can struggle is patience—they feel the need to always be actively trading. I liken a patient options trader to a batter in the box waiting for the perfect pitch—the kind of pitch that flies right over the plate and in your sweet spot. Those are the pitches you swing for because the time is right and the likelihood of success is high.
Patience in options trading is no different. If you have no game plan and trade recklessly, you’re likely to strike out. But if you wait for the perfect setup to come along in the right stock, that’s your slow pitch.
Identifying the difference between good trades and bad trades is most of the battle. Once you begin focusing on trading smarter, your batting average will start going up. The best batters and options traders out there aren’t necessarily the most gifted; their edge comes from being great at focusing their talents on those rare good trades.
Lucas Downey is Co-Founder of Macro Analytics for Professionals (www.mapsignals.com) where he produces long/short equity signals based on proprietary institutional accumulation/distribution research for institutional and retail clients.