I have recently discussed my personal approach to buying options in my personal account, either to take advantage of specific opportunities or to hedge positions in my long portfolio. Many of you have expressed interest in learning more about my philosophy on options trading.
Now, I would like to provide you with the same tools I use for more complex trades and help you gain the necessary knowledge and comfort level to engage in such trades.
The following series aims to offer basic education that can assist those who are interested in incorporating options as part of their overall investment strategy.
However, it is important to note that options are not suited for everyone.
Before we begin, I must emphasize that options inherently carry risks, and there is a possibility of losing 100% or more of your investment.
Let me illustrate with an example:
Suppose you buy 100 shares of XYZ at $10 per share, with an expectation that the price will reach $12 within the next month, resulting in a $200 profit.
If you are mistaken and XYZ trades at $9.50, you can limit your loss to $50 by selling the stock. Alternatively, if XYZ reaches only $11 by the end of the anticipated one-month holding period, you would still make a profit of $1 per share, totaling $100 or 10% return on the trade.
However, when buying an option, you need to be right about the direction, price, time, and volatility to make money. The price of an option depends on these factors and is not solely determined by price action like stocks.
Let's consider a scenario where you buy an XYZ $12 call option expiring in 30 days, when the underlying stock is trading at $12.
Here are a few possible outcomes:
If XYZ drops to $9.50, your $12 call option could significantly lose its value.
If XYZ fails to exceed $12 on the expiration date, you will lose the entire cost you paid for the option. It's important to note that options are wasting assets.
In other words, when buying options, you are playing against time. You are predicting that the stock's price will reach a certain level by a specific date.
Inexperienced traders and investors may find options challenging to comprehend, as they involve inherent risks. However, just like a chef's knife can be a valuable tool in the hands of a skilled cook, options can serve as an important part of an investment toolkit for traders who have the necessary expertise.