Disclaimer: None of the following is legal or financial advice in anyway, and respective advice should be sought from an appropriate professional.
I think it’s safe to say that financial literacy is the type of subject that the vast majority of people lack. The historical statistics shows 63% of retirees rely on some form of governmental support. Only 8% of people actually invest.
It’s not surprising, that money, finance and investing in general are the types of subjects that scare the crap out of people. When you couple a dark, murky & commonly hidden subject with desire or desperation, along with a dash of hope or fear, you have a perfect recipe for trouble.
It generally takes a major shift for someone … anyone to break away from the daily grind and take on the challenge of making their own money. Real estate is just one market, but the numbers … the cost of entry, simply either scare off or rule most people out of the game before they start.
There are other ways, but who the hell knows about those? The stock market? Sure, the barrier for entry is far, far lower than buying prime real estate, but what happens if the market … the economy tank?
The next step of the conversation typically looks like some variation of the following …
‘What if you can’t afford real estate, what happens if you can’t setup a strong stock portfolio … what if there are a way’s you can make money for a discount?
Huh? Lies! What? How? Where?
Who’s heard of Stock Options? These allow you to trade the stock market for a huge discount and still make money.
LIES! SCAMS! … what’s the catch?
No Catch, here is the trading screen … these are the numbers … this is the math … math doesn’t lie.
I sucked at math … but … but … I get the same answers … can I do this?
Anyone can do it … you just need to do this, this, that, calculate this, record that over here … hello?
The whole idea of options, and everything they can offer, the various strategies are incredibly enticing. When the regular first-time investor … first-time trader can actually verify the numbers independently across two or three sources, confirm the calculations themselves … options offers no room to hide. Everything can be done up front, known in advance to a high degree of certainty. Even the most sceptical minds struggle to defeat the math.
But the moment, it’s time to take action, the confidence evaporates. Any question is usually met with multiple answers, Options leads to choices, analysis, conditions … paralysis. The novice option trader, has so many more choices available than the average stock trader.
It’s then they realise they’re in the deep end. It’s then that the learning starts.
So, what is an Option Contract?
Without actually running some form of instruction here,
an option contract represents either the rights or obligation to buy or sell a stock at a specific pre-specified price … also known as the strike price.
That’s it, that’s all there is to it.
It’s when we delve into the four fundamental trades that the confusion starts to take over.
Selling a call, obligates the seller to sell stock if the price of the stock is at or above the strike price.
Selling a put, obligates the seller to buy stock if the price of the stock is at or below the strike price.
Buying a call, gives the buyer the right to buy stock at the strike price if the price is at or above the strike price.
Buying a put, gives the buyer the right to sell stock at the strike price if the price is at or below the strike price.
It has to be said here and now, there is a price associated with options contracts known as the premium. Buying a contract costs you the premium. Selling a contract earns you the premium. This is when the ‘party’ figuratively starts.
So, what is so confusing about them?
When most people think about investing into the stock market, the general consensus would be, buy a stock or ETF, and then sit back, do nothing and give the trade … or the investment time to grow and earn. This ‘Buy’ and ‘Hold’ strategy represents two of the fundamental moves a trader or investor can make, before finally ‘Selling’ at some point in the future to either book profit, liquidate or establish a new position.
There are literally three things one can do, Buy, Sell and or … wait and hold. Equity is proportional to value.
Simple option contracts do much the same thing, but they can be combined with stock, traded in isolation or combined for other strategies, and this is when people tend to simply get, lost, confused or both!
So, with so much opportunity and possibility for confusion why on earth would anyone use them?
There are 3 key reasons why Options contracts are used.
Firstly, Options contracts make the market and more expensive stocks far more accessible to retail traders. Depending on the time of the contract validity, the cost of a singular contract can be between 1 or 10% of the stock value.
We’re talking about up to or more than a 90% discount on the value of the stock itself. This allows a retail trader to trade stocks that otherwise they wouldn’t be able to afford outright and reduce risk accordingly.
Secondly there is the ability to leverage a position to achieve a disproportionate asymmetric risk-reward to the trade.
Although an option contract can be purchased for a fraction of the cost of the stock itself, the contract can make the same amount of profit as one would make when holding the stock outright. That being said, the reverse applies when selling options.
Finally, there is the flexibility that comes with them.
Related: When and How to start investing
A Strategy for every situation
When we think about Buying and Holding stock, strategy doesn’t exactly seem like the type of thing that factors into the long-term outlook. There are ways to protect against the downside with contrarian positions, but even those aren’t a guarantee under the right or in some cases the wrong circumstances.
Options however are the ways in which strategy can be implemented, and there is a strategy for nearly every type of situation that you can think of, bullish, bearish, neutral, volatile, hedging or even just for income.
By the time one gets to learn about how to setup for each of these situations, there is nearly (I said nearly) no need to ever need to get your hands-on full fat stock.
That being said however, there is no such thing as a one size fits all trade, and this is where things can really go off the rails.
Related: Covered Calls … The Perfect Strategy?
Why so Confusing?
Earlier I mentioned how the 4 fundamental trades were reduced to simple rights or obligations. Just on their own, these can cause confusion or at the very least be implemented incorrectly leading to problems.
Where the confusion typically starts is with the intent of the trade, and the intent must match the setup – this is non-negotiable.
If the setup and intent looks bullish, then the trade should be bullish. If the trade is a bit too rich for your account, then you can look at a bullish spread. But changing the potential trade changes how the trade will work, it also changes the potential risk-reward profile. If that’s too expensive, you can look at trades that are even cheaper, but demand that you not only be right in the direction of the trade, but also demands that you be correct for the price outlook at the right time.
As I’ve just said above, it’s when contracts start to get combined, that the mental gymnastics starts.
I think it’s safe to say, most people can understand the concept of buying a $50 stock and that if it grows by $10, then you’ve made $10 per share.
But on the other hand, saying that a spread costs $1, has a maximum profit of $5, and the stock needs to move by $10 prior to expiration to get it … that is enough to get a lot of people wondering how it works or what the **** is going on!
It gets better when a trade might cost $0.50, have a max profit of $5 (which you actually cannot get), the price must stay the same as where it is up to the time of expiration and should be closed when it reaches a value of $3.50.
There are multiple strategies, each for a different situation … hell, with options you can even make money if the stock price makes a rapid move up or down, within a single setup.
That is just three quick scenarios … now factor in that there are about 20 of them with variations.
Related: Why the Rich just get richer?
How you can get on top of them
Start slowly. Options are like an Iceberg, initially there is what you see, and all of the possibilities lie below the surface.
There are about 20 different strategies, and many can be flipped inside out, and back the front. This compounds the possibilities and the financial academics even further, up to about 40-50 different useful variations, many of which actually will never be used nor need to be … a far cry from the ‘Buy, Sell and Wait’ choices.
Ultimately … Learn one strategy at a time, and really learn it! Learn the strategies that suit you and your psychology.
Options offer rights, and obligations to the trader depending on the trade.
Option contracts and option spreads offer a myriad of ways to trade the market, however under no circumstances should ‘anyone’ look at the low costs against the stocks and jump in with both feet.
Although you don’t need to know every strategy you ‘can’ use, any would be option trader should be aware of at least 3-5 key strategies, when they should be used, and the appropriate risk and reward calculations that go with them.
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