Four Stages of a Successful Investor – Stage Four: Options Investors

Continued from yesterday’s stage three post.

Stage Four – Options Investors

Most investors do not make it past stage three.  The reasons can vary from a lack of knowledge regarding options, fear of the risks of options (I’ll debunk this fear in a minute) or just a state of being content with the gains they are making investing in individual stocks.  These reasons do not make an investor bad, but they do cause lost potential and greater risk.  Investing without using options as part of one’s arsenal of tools is like playing golf without a putter.  If you are a professional you will still beat most amateurs as you can still get the ball in the hole using another stick, but there’s really no reason not to use all available tools if it will improve your game.

Stage four investors have discovered their risk tolerance and understand their own individual investment personality type and use options to capitalize on it.  Stage four investors understand that risk not only describes what can be lost in a bad investment, but also what profits can be missed in a bull market.  The risk of not making money when the opportunity is available is just as much of a concern as losing money through a bad investment.  We recognize we cannot escape unscathed from every bad day, month and year and we must make the biggest gains possible while we can.

Options offer stage four investors what we need to beat the indexes while reducing risk.  The last two words of that sentence are crucial to a successful investor.  Reducing risk should never be taken lightly as the lure of big profits through options can easily draw in a novice like a siren draws in a sailor to his rocky demise.  If you think that sounds too dramatic then you have not had the “opportunity” to learn from an overextended options position that goes against you.  Trust me, it feels about as good as crashing your boat into some rocks and can cost as much to repair the damage.

The misnomer that options are risky is spread by those who do not understand options.  When used correctly, options reduce risk while increasing the likelyhood of larger gains.  I’ll be so bold as to say that I can never see the reason to enter a position on an optionable stock without using an option as part of my method of entry into the position.  Those without an understanding of options might condemn that statement as cavalier.  I’ll explain why I am right in each situation below with a simplified view of some ways to use options as part of any direction a stock is expected to move.

• You find a stock that you believe will take off to new highs soon with little risk to the downside.  This is the time to buy calls.  Calls give you unlimited upside potential with minimal downside risk.  Risk is reduced on this position because the most you can lose is the price you paid for the call.  If the stock falls you limit your losses.  An alternate move is to sell a naked put in-the-money.  You have no initial investment to make with this move and gain on the intrinsic value of the stock and any time value in the option’s premium.  Risk is reduced with this move by the premium received which includes time value which reduces your cost to buy the stock.
• You find a stock that is probably going to go up some over time, but could dip before it climbs.  This is the time to sell a naked put out-of-the-money.  Selling (aka, writing) a naked put takes no initial investment in the stock, but obligates the seller to buy the stock if it the buyer wants to sell at the lower strike price.  Downside risk is reduced by creating an entry point below the current price of the stock at the price of the out-of-the-money put’s strike and by the premium received which further reduces your cost per share.  Being assigned a stock after writing a naked put is like being paid a bonus for using a limit order to buy the stock.  The stock could continue to fall, but at least your entry point is below where the stock was trading when you made the decision to get in.  If the stock does not dip and you are not assigned the shares you are able to keep your profit from the premium and move to the next trade with realized profits in your account.
• You find a stock that will likely remain flat for a while.  You have a few options to use here.  You can sell either a naked call or a naked put or could do both.  If you believe the stock is not going to go up or down you have the ability to make money on it while it doesn’t move.  In selling naked options out-of-the-money you are only selling time value and no intrinsic value.  You make money on someone else’s belief that the stock will move in either direction.  This can be a very risky move if the stock does move big in either direction since you will be obligated to buy or sell the stock depending on which way it moves.  To hedge this risk you can buy options farther out-of-the-money which cuts your profit too.  It’s basically a risk and reward decision to make.  Selling both calls and puts on a stock reduces the risk of not making money when a stock is flat or only trades in a narrow horizontal range. 
• You find a stock you are slightly bullish on, but don’t think the price will increase very much in the near-term.  The option move on this one is to write a covered call or naked put.  A covered call out-of-the-money would be ideal if the stock rises to the strike price giving you an increase in stock value while at the same time you take a profit from the premium received through writing the covered call.  Risk is reduced with either move as the cost per share decreases due to the premiums received.  The risk of not making a profit if the stock stays flat is reduced because as a seller of options you receive your profit at the beginning of the transaction.  
• You find a stock that you think will go down and want to short it.  The option trade on this is to buy a put or sell a call depending on how much you think it will go down.  Buying a put allows you to profit while the stock sinks while limiting your loss to the price you paid for the put if the stock price goes the opposite direction.  Selling a call requires no output and reduces risk by giving you a cushion if the stock goes up some instead of going down. If the stock price goes above the strike price you will be obligated to sell the shares at expiration (if not sooner).  That is a risk, but smaller than if you had already sold the shares short at a lower price with no premium received.

With all of that said, using options may not be possible for every stock.  Not all stocks are optionable, meaning that not every stock trades options.  Even if no options are used for individual stocks, buying options on an index to hedge other long positions is still a wise move.  For some, this is a way to ease into options and learn how their prices move as the factors that determine an option’s price can differ greatly from the factors that move a stock’s price.

With options, investors are forced back to trading in lots of 100 shares of stock as each option represents 100 shares of the underlying stock.  This can be good and bad.  New options investors need to be careful about becoming over extended.  Once accustomed to the power of options’ leverage an investor can increase gains using less money which is the point of investing, making more money while risking less.

If you are not reading this post on www.mytradersjournal.com you are reading it from a site that has plagiarized it.  I’ve had to add this notice to the end of every post with the growing number of scum out there who steal posts and don’t credit the authors.

If you want to learn more about options, check out these earlier My Trader’s Journal posts:

How to Read an Options Table and How Put selling Works