The options trading market has become increasingly popular over the past years. Especially, due to the current economic situation that has affected stock markets globally, options are widely regarded as a safe investment choice with a potential of high return on investment. Options give investors the right to buy (call option) or sell (put option) an asset by certain date (maturity date) at a certain price (strike price).
The reason why options are considered a wise investment during turbulent financial times is because they become more valuable as markets become more volatile. If you own a call option, you benefit from price increases and have limited downside risk from price decreases. If you own a put option, you benefit from price decreases and have limited downside risk from price increases. Moreover, buying options requires much less money than purchasing stocks. This automatically reduces the risk of losing money.
There are a lot of strategies you can use when investing in options, including low risk and high risk, depending on your investment profile. However, there are also some commonly made mistakes that investors do and can trade off for all the benefits you could derive from options trading.
Here are the do’s and don’ts of options trading:
Do’s
a) Educate yourself about options trading as much as possible. Stocks and stock options are two different things and can give you different return on investments. Ask your financial advisor, your trader, go online, read articles, but before you decide to invest in options trading make sure you have understood the difference between the two so that you know what to expect.
b) Consider the relationship risk and return as you would do in any type of investment. Options trading may leverage the downside risk more safely, but there are risk factors involved that have to be considered in order to decide if it is profitable to enter in a particular trade or not.
c) Familiarize yourself with technical analysis in order to identify break-even points and profitability indicators. This will help you decide if it would make sense to exercise your option before maturity.
d) Buy options on stocks you believe they will increase in a short-term horizon, but you cannot afford to buy their shares. If a stock price is high and you feel it will go up over the next months, but you need a lot of money to purchase it, you can purchase all the call options on the stock, instead of the stock itself. In doing so, you give yourself the opportunity to purchase the underlying asset without being obliged to spend a ton of money.
Don’ts
a) Do not undertake too much risk. Typically, you should not risk more than 2%-5% of your portfolio in each option trade.
b) Do not risk more than 10% of your total portfolio value in option trades.
c) Do not invest in options unless you fully understand and appreciate the risks.
d) Do not engage in too much trading. Overtrading in options may lead you to lose money, despite the protection of downside risk, because the strategy you follow may not be the appropriate one given the market conditions at the time.
e) Do not allow your emotions to make you impatient. Impatience can be a bad advisor in investment decision making, especially when it comes to option trading.
