Justin’s note: In last week’s Dispatch, I explained why master trader Jeff Clark says we’re entering the best time to be an options trader. In short, with volatility rising, you can really juice your returns in the months ahead if you know what you’re doing.
If you’re interested in learning more about Jeff’s strategy, today’s essay is a must-read. Below, Jeff explains the common misconceptions about options trading… and how you can use it to reduce risk…
By Jeff Clark, editor, Delta Report
Most people say option trading is risky.
Novice traders often don’t take the time to learn the right way to use options. They jump right in – thinking, “I got this.”
They gamble, blow up their accounts, and then walk away penniless and swearing off options forever.
Even experienced traders sometimes get caught up in the allure of fast gains. They overleverage their positions – take a bigger position size than they should – and then take a hit. All the option traders I know, including myself, have blown up their accounts at least once.
But it’s not the option that’s risky… it’s the strategy. And when used the right way, options are far less risky than trading stocks.
You see, most people use options the wrong way. Most people use options to increase leverage… to get more “bang for their buck.” In other words, most people use options to increase risk.
That’s wrong. That’s the exact opposite of what options were designed for.
The options market was created so investors could reduce risk. Options allow investors to hedge their positions… and to risk much less money than they would buying a stock outright.
Let’s say you want to buy stock in Company X. It trades for $10 a share. You could put up $1,000 to buy 100 shares… But you can control the same amount of stock with one option contract. You can buy a contract for, let’s say, $50… and leave the other $950 in your account.
If Company X’s stock goes up, you’ll make money. If the stock goes down, the most you’ll ever lose is that $50. That’s a 100% loss… but it’s a lot less than potentially losing 20% or more of the $1,000 you risked buying the stock.
This is a simple example. And it’s the simplicity that proves my point… Options allow you to risk much less and profit just as much as buying stocks.
But that benefit disappears if you overleverage the trade and take on a larger position with options than you would otherwise take with the stock.
That’s the biggest mistake most novice option traders make. Instead of replacing a 100-share purchase with one call option, they take the entire amount they would have allocated to the stock and buy a much larger position with the options.
Rather than buying one call option for $50 and leaving the remaining $950 in the bank, novice traders take the entire $1,000 and put it into buying more call options.
They end up buying 20 call options to try to get more bang for their buck. What would have been a 100-share purchase has turned into control of 2,000 shares. Instead of using options to reduce risk, they’ve increased their risk 20 times.
Losing 100% on an overleveraged trade would be a disaster. And it’s why most folks think option trading is dangerous. But it’s not dangerous if you trade options the way they were originally intended… as a way to reduce risk.
Limit your option exposure to control just the number of shares you would normally purchase. Leave the rest of the money in the bank. Then it won’t be so bad to lose 100% on an option trade.
It will almost always turn out better than what you could have lost on the stock.
Best regards and good trading,
P.S. I’ve been busy digging up promising new trades for my Delta Report readers.
In fact, I sent them a trade yesterday with the potential to earn over 60% in the next couple months. And this one’s special… because one of my favorite stock market anomalies supports the case for a breakout move.
To learn more about this anomaly, and how you can use it to find similarly promising trade setups, click here.
Today, kind words for Doug Casey:
Hello Doug, Thanks for your great research in natural resources. And for your useful insights and comments on the other subjects. I look forward to them being increasingly helpful in the near future. Thank you for your kindness. The best to you.
I can’t think of a single person that I would want to share a phyle with. That includes some members of my own family. Most people won’t even listen politely when I suggest that the US government will run out of money and all of the zombies will take to the streets with torches and pitchforks, looting and burning. That can’t happen here, this is America! I see the government as being like Saddam Hussein in Iraq, before the US dumped over the apple cart. Most Iraqis went about their daily business in reasonable safety and security, because Saddam was holding all of the factions apart and keeping order. He was also helping himself to whatever he could steal. After he was deposed, all of these groups began fighting for control, it was no longer safe to conduct business. Even neighborhoods were like separate countries.
I believe a similar fate awaits us in the good old USA. If I was not 78 years old and dealing with a sick wife, I would be off in some foreign bolt hole eating pineapples, bananas and watermelon for breakfast and walking on a deserted beach every day. I look at my neighbors and wonder if they will want to raid my pantry.
Honestly, if I hadn’t read other things by Doug Casey, I’d probably not pursue reading more after Nation States 2. Is he serious about only associating with those who would meet his standards? Poor people don’t bring much to the party? That’s a pretty limiting world view! What about the poor slobs that inhabit your life, otherwise say, fix your car? Wait on you at restaurants? Clean your house? Evidently their lack of money makes them uninteresting. God forbid he might dig a little deeper to appreciate skills, talents, outlooks, experiences of the less wealthy, attributes that can enrich in a different way.
That said, other aspects of his crisis investing outlook are being taken to heart and acted upon, such as putting some money in a foreign country. While it’s a bit extreme with the enormous debt of our country, I think he is correct that this could cause a financial breakdown, ruin the banks, etc. So if you have the ability to put some money in a country that is less beholden to its creditors, why not do that? It’s late and now I’m rambling, and in all fairness, perhaps that was the case when Doug Casey wrote Nation States 2.
As always, if you have any questions or suggestions for the Dispatch, send them to us right here.
Did You Reserve Your Spot?
It’s not too late to sign up for our Pot Stock Millionaire Summit on Thursday, April 26 at 8 p.m. ET.
If you’re thinking about investing in marijuana stocks, we urge you to attend this free event. For more, click on the video below to hear from Doug Casey himself…