Option trading can deliver tremendous profits, but the flip side of those gains is the potential for tremendous losses, since option trading is a zero-sum game. Those who are just getting started with options need to be particularly careful, because option strategies can be complex. Options offer what often looks like easy money, but it can turn out to be some hard money to earn.
Here are three option strategies that new option traders should avoid and why.
3 option strategies that are too risky for new investors
The three strategies below can pose significant risk for traders who don’t know their way around the option market. While all legitimate strategies, they pose significant risk for the uninitiated.
1. Uncovered call
The appeal of selling options is that it can look like free money, and that’s the case with the uncovered call, which provides an upfront cash payment. In an uncovered call, the trader sells a call option on a stock, promising to sell the stock at the strike price for the life of the contract. If the stock doesn’t close above the strike price at the call’s expiration, the trader keeps the cash. With upfront cash and the potential to have to do nothing else after being paid, it does look like free money.
Why to avoid it: While the trader may not have to make good on the promise to sell the stock later at an unfavorable price, the trader still assumes the risk of having to do it. The particular danger of the uncovered call is that if the stock rises significantly before the option’s expiration, the trader could lose many times the money that was received upfront. In fact, the potential risk is unlimited, as the stock could soar with no limit to how high it could rise. The upfront premium payment may end up looking minuscule in the light of an enormous loss if the stock zooms up.
2. Long straddle
The long straddle can be a useful strategy if you think a stock is going to make a big move, but you’re not sure in which direction. This strategy involves buying a call and a put option at the same expiration and same strike price, typically as close to the stock price as possible. If the stock makes its big expected move, one of the options could go up significantly, returning many times the strategy’s large investment in options premiums.
Why to avoid it: The long straddle can require a big move from the stock to break even, because the strategy requires the trader to pay two premiums to set it up. The strategy won’t turn profitable until the stock gains or loses that initial double investment. And only one option will help get you there, as measured at expiration, because if the stock rises, the put expires worthless, while if the stock falls, the call expires worthless. In other words, if you paid $5 for each option to set up the straddle, the stock has to move higher or lower by $10 before you start winning.
3. Deep out-of-the-money long options
New traders may be enticed by the potential of buying deep out-of-the-money options, because they offer a low price — perhaps just $0.10 or $0.15 per contract. If they surpass the strike, the trade can make a ton of money. There’s no arguing with the math, but the probability is another question. Deep out-of-the-money options are those where the strike price is far away from the stock price, either a call with a much higher strike price or a put with a much lower strike price.
Why to avoid it: The ultra-low price on the options tells traders that the market assigns little chance of the stock ever exceeding the strike price. The chances are so low that you’re throwing your money away when you could be making a better trade that will return less money but have a much better probability of being profitable. A tiny slice of something is better than a huge slice of nothing.
2 safer option strategies for beginners
Rather than take a chance on the riskier strategies above, it can make sense to go with safer strategies that offer better odds. Here are two alternatives that could be better for new traders.
1. Covered call
Whereas an uncovered call sells a call without any protection, a covered call involves owning the underlying stock and then selling a call for every 100 shares owned. The covered call generates income and hedges the risk that the stock soars. If it does, your ownership stake in the stock fully offsets the loss in the option. Yes, you don’t earn the gain from the stock that you otherwise would have earned, but you don’t have to scramble to make up the loss, either.
The covered call is one of the best options strategies for new traders because it limits risk and can deliver income. The strategy can even be used in an IRA to generate tax-deferred or tax-free income (depending on whether you have a Roth IRA), and is popular with risk-averse traders.
The best brokers for options trading can help you identify stocks that are attractive candidates for strategies such as the covered call.
2. Synthetic long
A synthetic long uses options to create the payoff of owning the stock directly. Specifically, it involves buying a call option and selling a put option at the same expiration and same strike price, which should be at or around the current stock price. The payoff profile looks exactly like that of the underlying stock at expiration. If the stock rises, the call rises and the put expires worthless. If the stock falls, the call expires worthless and the put rises in value, creating a loss.
The advantage of the synthetic long is that you don’t need to front much — if any — cash to set up the strategy, since the short put covers most or all of the cost of the long call. So you could literally enjoy all the upside on the stock without a net investment in it. The flip side is that if the stock falls, you have to be prepared to purchase the stock at the strike price, and having cash in your account or at least the margin capacity to do so is an absolute necessity.
Bottom line
Options offer the potential to make a lot of money — and it’s true. But the risks involved mean that new option traders should go slowly at first and take advantage of “high-percentage” strategies before they try riskier strategies that may have a low chance of success or a low payoff.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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