#21 - Dangers Of Trading Options
Hey everyone. Kirk here again at Option Alpha and welcome back to the daily call. Today, we’re going to be talking about the dangers of trading options. Now, for full disclosure and of course, I probably have to say this legally, it’s all over our website legally anyway, but of course, options trading is risky because it’s a leveraged asset and when you use leverage, leverage can hurt and leverage can help. I often relate this to actually driving a car because a car is leveraged, leveraged to get from one point to the other point faster, but if you use leverage in the wrong direction or too fast, too slow or incorrectly, it can be dangerous. If you drive a car backwards down the highway at 70 miles an hour, that’s not what it was intended to do and therefore, it can cause harm. It can be very, very risky versus just like for example, walking from point A to point B. But in options trading, the same concept proves and that is if you use it the right way, it can help you get from point A to point B much faster and even probably much safer, but if you use it the wrong way, then it can obviously hurt your account. It’s also been proven not only by us, but also by very reputable firms out there, also the CBOE, OCC, OIC that options trading in conjunction with modern portfolio theory can be much more profitable and can also lead to lower volatility in your account which means that your portfolio growth is at a much more steady pace versus lots of ups and downs. Specifically, the dangers of options trading are one, that trades go against you which we know will happen. That’s all dictated upon where you place your trades for probability of success. I often tell people and I ask the question for coaching clients when they first start with me, we’ll often ask and say, “What probability of success would you like to hit?” They say 70% or 80% or 90% and then they say, “Do you think that’s possible?” I say, “Well, look. Anything is possible because it’s basically where you want to play the game, where you want to place your bets.” In options trading, you determine where you want to place your strike prices and how you want to setup your trades. Therefore, you determine how successful you will be in trading probability of success wise. Now, we’ve done other podcast and other training on just maybe what the most optimal levels are. You check out our toolbox software just to get a little bit more insight into that. But in options trading, you do have the possibility to actually lose money depending on what probability of success you setup. Now, the next stage of this and where I think that most people often fail is in over-allocation. In options trading, it’s very easy because of the leverage. You can actually control a lot of shares of stock with very little money. It’s easy for people to over-allocate and invest too much of their money in one particular ticker symbol versus another. What we say at Option Alpha is that everything should be under 5% risk per trade which means that if a stock or an option position has the possibility of losing $500, that $500 better be 5% of your account. If that position has the possibility of losing $10,000 and $10,000 is way over 5% of your account, then you probably should scale back that trade or not do that trade at all. Just skip it completely. But if you don’t do that, then you have the possibility that a few bad apples, a few bad trades in the mix which you don’t know when they’re going to come, you don’t know when the next trade is going to be good or bad, it could actually blow up your account. This is why I think most people actually fail, is just because they over-allocate. The next danger of trading options is just assignment of stock. This to me really isn’t a danger. I’ll say it’s a danger because people are really afraid of it. They don’t understand the process. But assignment of stock is not that bad at all. In fact, it’s completely manageable. If you’re assigned stock, all you simply can do is close it out if you don’t have the capital to keep it. If you have the capital to keep the stock short or long, then you decide to keep the stock short or long. It’s really that simple. It’s not that bad. It’s a little bit different of a process to convert things from options to stock, but it’s not that bad. It happens less than 1% of the time based on when we tested it. The other danger of options trading is that you end up chasing the market a lot. What a lot of people often do when they trade options is they try to day-trade options and pick direction and when you do that, you end up just turning your account a lot. You’re just chasing the market. You’re like a dog that chases its tail around and around in a circle and you end up going nowhere. You end up just treading water instead of actually making progress. What we suggest at Option Alpha is that you actually take a different approach. You basically let the market move, you choose a range within how you can profit, so you can build a strategy, so that you can profit within a range of market movements and then you collect income from the market. Very similar to how insurance companies sell insurance or how casinos operate their business by collecting bets and then paying out here and there to large winners. At the end of the day, those large winners never overshadow lots and lots of small collections of bets. At the end of the day, I don’t think that options trading is necessarily that dangerous. I think the actual individual investor could probably be more dangerous if they’re not doing it right. Just like I don’t think a car in and of itself is dangerous just there sitting in the driveway. I think the operator makes the car either dangerous or safe. Until next time, happy trading!
