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The Right Way to Trade with Options

By Jeff Clark
Thursday, July 18, 2013

I lost 100% of my money last month.
It happened to me in May, too... and the month before that. You see, I trade options... and I make a lot of trades.
Sometimes those trades are profitable. Sometimes they're not. When they're not profitable, the options often expire worthless and I suffer a 100% loss on the trade.
But I'm OK losing 100% on an options trade. It is almost always better than losing a smaller percentage on the stock. Let me explain...
Back in May, I went bottom-fishing in the coal sector. Coal stocks were having a horrible year. But they were showing signs of bottoming. And given how oversold the sector was – and how negative investor sentiment was toward coal stocks – I figured they could bounce sharply. I liked the risk/reward setup for an option trade. So I bought the Peabody Energy (BTU) June $22 call options for about $0.50.
In other words, I paid $0.50 per share for the right to buy BTU at $22 per share (the "strike price") by option expiration in June. At the time, BTU was trading for about $21 per share.
By June expiration, the stock was below $16. I wasn't going to pay $22 for a stock trading at $16. The BTU June $22 call options expired worthless, and I lost 100% of the money invested in that position. But losing $0.50 on a call option is a lot better than losing $6 per share.
Here's another way to think about it... If I had bought 100 shares of stock, I would have committed $2,100 (100 shares at $21) to the trade. That money would be at risk and subject to loss.
Buying one call option contract also controls 100 shares. But the premium was only $50. So there was much less money at risk.
That's the real benefit of trading with options... there's far less risk than trading the stock.
Of course, that benefit disappears if you over-leverage the trade and take on a larger position with the options than you would otherwise take with the stock. That's the biggest mistake most novice options traders make. Instead of replacing a 100-share purchase with one call option, they take the entire amount they would have allocated to the stock and buy a much larger position with the options.
Rather than buying one call option for $50 and leaving the remaining $2,050 in the bank, novice traders take the entire $2,100 and put it into buying more call options.
He'll end up buying 42 call options to try to get more bang for his buck. What would have been a 100-share purchase has turned into control of 4,200 shares. Instead of using options to reduce risk, he's increased his risk 42 times.
As you can see, losing 100% on an over-leveraged trade would be a disaster. And it's why most folks think options trading is dangerous. But it's not dangerous if you trade options the way they were originally intended... as a way to reduce risk.
Limit your option exposure to control just the number of shares you would normally purchase. Leave the rest of the money in the bank. Then it won't be so bad to lose 100% on an option trade. It will almost always turn out better than what you could have lost on the stock.
– Jeff Clark

Further Reading:

If you don't know what you're doing, buying options can be risky. But there's a way to use options to generate 5% or more every few months, with much less risk than owning stocks. "No other strategy offers a chance to safely profit, no matter what happens to stock prices," Dr. David 'Doc' Eifrig says. Get all the details in this interview with Doc.
You'll never be truly successful in any market if you don't know the basics of position sizing. Position sizing tells you how much money to place into a given trade. It's "the first and probably most important way investors can protect themselves from what's known as 'catastrophic loss,'" Brian Hunt says. Learn how to put position sizing to work for you in this interview with Brian.

In The Daily Crux
Market Notes
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