It is often said that trading options is risky and fraught with unknown dangers, it’s difficult to learn and difficult to do, especially for new traders. We don’t agree. Read on to find out why.
Different Kinds of Options
An option is a derivative of an underlying instrument that expires at a set time.
Option contracts are issued against various asset classes including stocks, bonds, currencies or commodities and are combined into option chains. Buying an option, whether it’s a call or put option gives you the right, but doesn’t oblige you to buy (if it’s a call option) or sell (if it’s a put option), the underlying asset for a certain price on or before a certain date.
For more advanced traders, selling an option, that is selling a call option or put option – puts you under the obligation but doesn’t give you the right to sell the underlying asset (often just referred to as ‘the underlying’) within a specific period of time. In other words, you are obliged to honour the strike price if the option contract is exercised.
In reality people trading smaller accounts of say between US$5,000 to $25,000 will only be trading buy call or buy put options. Those with larger account sizes – for example US$100,000 or more – will be trading both buy and sell options as part of combined option strategies.
The Benefits (Once You Know What You are Doing)
Certainly we wouldn’t advise anyone to venture into trading options until they have got a solid handle on managing trading risk. But that goes for any kind of trading.
Once that and some basic know-hows are in place, there are particular benefits to trading options. For example, they suit people who want to trade while also working a full-time job as options trades run for days and weeks as opposed to intraday trades that run for minutes therefore requiring more time during the day.
Also you don’t have to tie up a lot of your capital in each trade and it’s a defined risk, at least with buy options where you can’t lose more than the premium paid for the option. This can be attractive to the new trader as options are a lot less capital intensive than buying stocks.
Why a Newbie Can Trade Options
Trading derivatives is generally not considered the place for new traders to cut their teeth and as such options are not considered to be any different. This is because of the risk associated with options and the fact that there aren’t any stops unlike with CFDs.
But new traders can trade options if they are trained correctly from the start and have no pre-conceived ideas. Most will spend thousands of dollars on training just to end up not becoming profitable.
The first building block is to have solid risk management skills. Next it’s about making sure you have a thorough understanding of the instrument as well as probabilities and time horizons.
It’s important to question whether your expectations for the underlying stock hitting the breakeven point and target price are realistic and to do your scenario calculations before you put your trade on.
What Experienced Traders Need to Remember
Don’t forget that directional bias (long or short) can be used to set up great option trades. VSA helps with that especially.
A common mistake is not to check the expiry date of the options and then select the wrong strike prices. People tend to place option trades without calculating the risks and effectively throwing their money away.
For example a trader might buy a call for US$50 on a $200 strike that expires in a month but if the underlying is currently trading at $80 then it might need a lot more time to get to $200 plus the premium paid for the option just to get to break even. It is therefore more likely that the option contract will expire worthless. That’s unnecessary money lost.
Another trap is to think that there is a value in buying an option just because it is cheap. In reality, you always need to look at the risk scenarios, calculate the likely outcomes and decide which is best in terms of strike price selection and for you as a trader.
Finally, avoid placing naked options which is when you sell an option and don’t own anything that can cover you if the trade goes against you. All your assets are on the line when you do this. This is what happened, infamously, when Nick Leeson brought down Barings Bank to the tune of US$1.4 billion with a series of naked option trades.
Selling options does have its place as part of multiple strategies that provide coverage, for example covered calls and option spreads. But never trade naked options no matter how alluring it may seem.
Anyone new to trading or trading options should avoid option selling strategies until they are experienced and profitable trading buy only strategies.
Want to upskill on your options trading?
Options trading can be learned and is a trading discipline in its own right. To support anyone who wants to acquire this skill we’ve developed a suite of courses that are for both for newbie and experienced traders alike.
They have been put together by Coenraad Bezuidenhout who was a hobby trader for about 10 years until the pandemic when he started doing it full time. He’s been using VSA since 2020 and trading options since 2021. Coenraad also trades for the Tradeguider Asset Management Fund. You can read more of his approach in this blog about trade entries and exits and this one about switching from end of day trading to intraday trading.
You are the home of Wyckoff VSA. The VSA methodology works well for options trading because it helps you identify directional bias which is needed for profitable options trading. Don’t know what directional bias is? Want more info about VSA? You`ll find us here.