Markets

Five Major Myths about Options Trading

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When it comes to investing, pretty much everyone has an opinion. While those opinions are great, sometimes investors will spread myths about subjects they don't have a firm understanding of. One of the most confusing subjects is options trading . Due to the many moving parts involved, investors find themselves befuddled and not knowing where to start. Here I'm going to debunk five major myths of options trading.

Myth #1: Options are Riskier than Stocks

This is one of those broad-based, blanket statements that does not tell the whole truth. People think options are riskier because you can lose 100% of your investment in an option. However, you can use options to limit your risk on trades.

Here's an example, let's say you wanted to buy 100 shares of Tesla (TSLA) ahead of their earnings report next week because you think they are going to have a good report and the stock will go up. Today it would cost you around $270 per share or $27,000 to own 100 shares. If TSLA goes down 10% on its earnings report, you are going to lose $2,700 dollars. If it goes up 10%, you'll make $2,700.

On the flipside, you could buy the March 17 th $270 Call option for $1,350. If TSLA goes down 10% and stays there through expiration, you'll lose your $1,350. If it goes up 10%, you're call option will be worth at least $2,700, maybe more. If you wanted to define your risk as $2,700, you could buy two of these contracts, controlling 200 shares of Tesla rather than only 100. Same amount of nominal risk, but now your upside potential is doubled.

Myth #2: You Need to be a Sophisticated Trader for Options

There certainly are options strategies that involve a great deal of complexity. With so many choices available to trade it can be very complicated. Each options expiration date has call options and put options of varying strikes available. At first glance the selection process can be daunting. Many stocks now have weekly options expiration, making these even more overwhelming for investors.

You don't need a PhD in Applied Mathematics to use simple options strategies to make money and create income. For example, buying a call in the hopes that a stock goes up. If you know there is an event coming up that you think the stock will profit from, you can buy a call near the money on the stock and if it goes up you can profit. If you want to make a trade that benefits when the stock goes down, you can buy a put option in the hopes the stock goes down. Start with the basics and add more complex strategies as you become more comfortable.

Myth #3: It Takes a Lot of Money to Trade Options

This couldn't be further from the truth. It's a lot less capital intensive to trade options than it is to buy 100 shares of your favorite stock. Most brokerage firms allow you to sell options premium, a more advanced strategy, in accounts that contain as little as $2,000. Compare that to Pattern Day Trader accounts which require at least $25,000.

Trading options allows smaller accounts to gain exposure to more stocks for less money. You can diversify your options trades across many industries and many stocks simultaneously. There are even options on ETFs like the Volatility Index (VXX) so you can gain exposure to exotic financial instruments while managing your risk.

Myth #4: Time is Always Working Against You

If you are long or buy options then yes, there is a time value element that's working against you. However, there are simple ways to flip the script so this time works in your favor. One way is by using long call and long put spreads rather than buying a call or put outright. The other is to use credit spreads.

A long call spread, or a bull call spread, is a two-legged options trade where a closer to the money option is purchased to open and a further out of the money call option is sold to open or shorted. This helps to drop the overall net debit or price of the call spread. It also limits the total profit potential of the trade.

For example, if I bought a March 17 th $67.50 Call on Gilead (GILD) today it would cost me about $2.95. My upside potential would be unlimited but my breakeven would be the strike price plus the net debit which in this case is $2.95, making my breakeven $70.45.

However, if I believe Gilead's upside is limited to $72.50, I could sell that $72.50 Call at the same expiration and take back some money, dropping my overall cost on the spread, therefore bringing down my breakeven. I could sell the $72.50 Call for 55c. Now my cost on the $67.50/72.50 Call spread is only $2.40, my breakeven now $69.90, and I'll make more money up to $72.50 than I would have with the long call by itself.

Another example is the credit spread. Rather than buying the aforementioned spread, if I'm bearish on GILD I can sell the spread. So instead of spending $2.40 for the spread I would pocket $2.40. My risk would be the $5 difference in the strike prices, minus the $2.40 I took in premium. So I risk $2.60 to make $2.40. This credit spread would max out or give me the largest possible winning outcome of $2.40 if shares of GILD closed at or below $62.50 at expiration on March 17 th .

Myth #5: You Need a Special Account to Trade Options

Well, sort of. While you do need to sign an options risk acknowledgement form and get your account approved specifically for options trading, it's not exactly a "special account." Pretty much any non-qualified, or non-retirement, account is eligible for options trading. I specify non-qualified because accounts like IRAs are restricted as to the type of options trading you can do since you can't short stocks in retirement accounts.

There are several levels of options approvals out there, designed to save investors from themselves. Each level or tier is restricted, only allowing certain types of trading. Each broker has their own guidelines for what these levels look like. All you really need for approval is experience trading and capital. It's not like you have to be a millionaire or anything.

Bottom Line

Those are the five biggest myths about options trading that scare off potential traders. If you take the time to learn more about trading options, you'll find that they are a great way to manage your risk and gain exposure to the stock market.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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