There has been a lot of interest from readers regarding learning about options and getting started in options trading. But first, I would like to offer the requisite disclaimers. I am not a professional options trader, but am simply an everyday individual who has been trading and using options for his own accounts since 1999. Through these 13 years of experience, I would like to think that I have learned a thing or two and would like to share these things with you so that you don’t make some of the same mistakes that I did.
It Starts with Education
Learning about options is much like learning an entirely new language. It is not that it is any more difficult than learning any other new skill like welding or accounting or Spanish. It is simply intimidating for many people because of the terminology and the fact that money is involved.
So the first thing that I would recommend is getting a solid foundation by learning about the terminology involved and reading a book or two on the subject. I counted my books on options trading yesterday and found 11 on my bookshelf solely devoted to the topic. I have many others on stock investing and real estate as well.
Of those that I have, there are two that I would recommend for beginners:
“Getting Started in Options” by Michael C. Thomsett which is available at Amazon for $13.57 and “Stocks for Options Trading: Low-Risk, Low-Stress Strategies for Selling Stock Options-Profitably” by Harvey Friedentag which is a lot more expensive, but worth it. This book is from 1999, and I noticed that he has a new book that came out in 2009 which I haven’t read.
You could search for these books and others through my Amazon link at the end of this article. I am an affiliate so would pick up a small commission.
Of course, there are plenty of free resources on the web to learn about the terminology. I am working on one such resource over at OptionsDudeAtoZ. You can also follow some of my trading at OptionsDude.com. There is also a forum over there where you could post questions. I would be happy to answer them and get into much greater detail.
Consider Paper Trading
It is always recommended that investors learning something new start with paper trading. While I have done a little, I must confess that paper trading just didn’t mesh with my personality. You have to understand that there is a big difference between simulated trading and trading when real money is on the line. A HUGE difference! Everything you thought you knew flies out the window once emotions become involved, and I guarantee that they will.
There is nothing wrong with doing a little paper trading initially to make sure you understand what you are doing and the impact that certain market movements will have on your positions. Just understand that it is different from actual trading.
Start With Level 1
If you want to trade options, you have to be approved by your brokerage. Brokerages have different levels of approval depending upon your amount of capital and experience. These levels will range from level 1 up to level 4 or 5 depending upon the brokerage. At E*Trade for example, level 1 only includes covered calls. Covered calls are considered the most conservative options trade, but I believe that the safety of covered calls could be a total myth. Be that as it may, it is still a good place to begin one’s understanding of call options.
For my next post, I would like to begin discussing covered calls and what I would do now following years of experience. I would like you to avoid many of the mistakes that I made. I do learn from my mistakes and have found experience to be a good and thorough teacher.
There has been a lot of volatility, fear and uncertainty in the stock market recently. Personally, I don’t think that there will be any changes in the near future and that the volatility will continue. I am still suspecting another recession in the next 12 months and a return of the Dow to 4 digits. Of course, I could be wrong but why take any chances? I will keep using protective puts on my retirement accounts. After all, they just saved me 9 percent of my portfolio. I am down about 4% since the downgrade.
Today is option expiration so those stocks that closed below the level of my puts yesterday will automatically be sold. I haven’t cared much that Akamai (AKAM) traded below $21 per share since I have puts that will be exercised at $27. They will sell today at $27 and I will have $6 per share extra in cash when I buy back on Monday. I will likely just sit on my current positions and wait for the carnage to end and a trend to re-establish. Then I can buy more shares with the cash that I have.
Avoiding Big Losses
I have become convinced that the best way to make money is to not lose big. Swinging for the fences makes for good stories, but winning is often times more about not making any forced errors. It is avoiding turnovers and protecting the ball. It is about controlling the game and not giving up a big play.
The same holds true for investing. I don’t want to lose 50% because it takes a 100% gain just to get back to even. I would much prefer to lose only 10% even if I have to give up a little bit of upside during bull markets. That is why I started using protective puts in 2007.
The timing couldn’t have been better since when the market was down big, I lost only 18%. It didn’t take long for me to get back to where I was before. You don’t necessarily have to use options to control your risk, but you should have a plan when investing whether it is “sell in May and go away” or dollar cost averaging or asset allocation.
For me, put options make the most sense. I have been trading options for over 10 years and have a good sense of how to use them. I have been sharing my trades on two of my stocks, SLW and ONXX, over at OptionsDude.com to give readers an idea of how I have been trading in my retirement. I actually thought my put options for both of these stocks would be exercised, but was surprised over the past week. The price of silver soared on Friday (and Silver Wheaton stock with it) such that I actually had one ray of sunshine in my portfolio.
This is a little shorter post than usual, but I wanted to share a little about how I am dealing with the volatility in the stock market especially now that options have expired, and results are in. I have been able to sit back and watch what is happening rather than worry too much about it.
Readers: What are your thoughts on recent market volatility? How have you been handling it? What are your plans going into the rest of the year?
I ran across this post on “Catching Falling Knives” at The Market Capitalist and felt that it was a great topic for my first post on options here at Cash Flow Mantra. Most people would be scared to catch a real falling knife, but if you do so with a little bit of practice and training, it can be done relatively safely. It can even be entertaining as seen here:
Now if I were to catch a falling knife, I might do so with a block of wood or a chain mail glove to keep from getting hurt. But if I want to catch a stock in free fall, I would do so with put options. Allow me to explain how to catch a falling stock by looking at a real life example.
Recently, Linked In (LNKD) issued stock in a much hyped IPO. The stock opened at over twice the offering price and shot past $120 per share, but then immediately began falling. There have been questions about valuation and earnings, but I am not interested in debating that. Rather, I am interested in how could you get involved in the stock not knowing where the bottom might be and still not get hurt!
It didn’t take long for options to start trading on the stock so here is what I would have done had I been interested. You could consider this type of strategy for Facebook when it comes out since it is likely to be a stock that will have some hype involved.
Let’s say that you would have wanted to get 500 shares of Linked In. That first day of trading it would have cost $50,000. But the stock started declining right away. Within a few weeks, the stock is at $70 per share. Is this a bottom? How low will it go? I have no idea, but I do have a plan.
When the stock is at $70, I could purchase 5 contracts of the $60 put that expires in November for about 25% of the value of the stock or about $17.50 per share. Each put contract covers 100 shares. The puts are very expensive for this stock since volatility is still high with real potential downside risk. Then I purchase 500 shares. So, what have I done?
I own LNKD and can brag to everyone at work. But my cost for the stock and the put options is $87.50. If LNKD is trading at $30 in November, then I can sell it for $60 but I will still lose $27.50 per share which is better than $40.
Alternatively should LNKD increase to $100 again like it did today on July 11, I will make a profit of $13.50 per share on the stock plus whatever value the puts may hold. Could LNKD go to $150? Sure. That would be great if I owned the stock. Could it go to 30? Sure. That would be terrible if I owned the stock.
The point is that puts can be used to limit the downside and allow you to pull the trigger on a falling knife. Puts are that chain mail glove protecting you while you practice juggling those knives. No sense losing a finger or a lot of trading capital.
There are even techniques that can be used that might even allow you to profit from a falling knife, like buying 8 or 10 put contracts on those 500 shares and selling off the puts one at a time as they increase in value and you wait for a bottom.
I use puts in my retirement accounts to double down and buy into a declining stock. I sold EMC from my account last November after holding for 3 years. My original purchase price was $25.37 in October of 2007. I watched it drop into the low teens but because I made money on the puts and was able to purchase additional shares with confidence knowing that it would eventually recover somewhat. I sold at $21.82 but made 8.7% annualized return over those 3 years because I averaged down. My basis ended up being $15.78.
I was able to invest without fear knowing that I couldn’t lose all of my capital. Plus, I made a better return than buying and holding in which case I would have lost money.
So reader, have you traded options? Do you think options are risky? Have you any idea what I was saying? Please offer your comments below. I will be working on another site that will start at the beginning and explain options in a simple manner so that anyone could understand and appreciate them.