Sunday, June 03, 2007

Whether to Trade Options

In the past, I suggested some questions to ask yourself to get a better feel for your own trading strengths and weaknesses. Among the questions were whether you traded options and, if so, why and if not, why not. Relatively few investors trade options. If you are among that majority, why don't you trade options?

I suspect that those who do not trade options steer away because they lack knowledge. Undoubtedly, many believe that trading options is very risky -- and it can be. However, would your mind open a bit to the concept of option trading if you knew that you could place a trade involving zero risk with the potential of making a 20% or 30% annual gain? That is a strategy that is available to someone willing to learn a little about options. In addition, an investor can even enter some positions where a profit is guaranteed at the time of entry with the potential for even greater gain over time.

Of course, most option trades do not have zero risk or guaranteed profit. Most strategies do involve risk. One of the most important risks faced by option buyers is that time is running against them. Options expire. If you buy a call option, for example, you want the stock price to go up and go up fairly quickly and definitely before expiration. If it does, you may realize a substantial high percentage gain. If the stock goes down or stays flat, you will likely suffer a loss and that loss could be your whole investment. The buyer of an option gains a great deal of leverage, and, in exchange takes on risk that time will run out before whatever he needs to happen happens.

Option sellers always take on an obligation. If they sell a call, they take on the obligation to deliver stock at a specific price at a specific time. The strategy of selling covered calls, for example, means that someone who owns stock (covered) can sell a call and bring in some income. If I owned XYZ, for example, and it was trading at $34.50, I could sell the call with the next month expiration and a $35 strike price for maybe 75 cents a share. If I owned 1000 shares of XYZ, I could collect $750 less a commission. Now, someone who bought that $35 call could require me to sell my XYZ stock to them for $35 a share. If they did and I had bought it at $34.50 a share I would make an additional 50 cents a share and, of course, get to keep the 75 cent premium for the calls I sold. In that example, all works out well. However, suppose my broker permitted me to sell naked calls (naked means I don't own the stock) and I sold the same $35 calls and got the same 75 cents a share. What if the stock took off and went to $50 a share. I would still have to sell the stock for $35, but since I didn't own any in the first place, I would have to go buy it at the market ($50) and therefore take a big hit. You see the varying degrees of risk between writing (selling) covered calls and writing naked calls?

Trading options can involve almost any level of risk from zero to theoretically infinite. If we are going to trade options, we must take the time to acquire the knowledge to understand the precise risk(s) we are undertaking with any given strategy. Once the risk is assessed we should be able to make an intelligent analysis of whether that specific risk is justified in the trader's personal plan by the potential reward and the assessment of the liklihood of obtaining the reward.

Bill Kraft, Editor
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