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Smart Options Trading

The Smart Profits Report: Issue #104
Thursday, April 22, 2004

Smart Options Trading: Four Critical Truths About Derivatives
By Karim Rahemtulla
Chairman, Mt. Vernon Research

I’d say it’s a safe bet that if you’re reading this column right now you own a range of stocks (domestic and international), bonds, index funds, perhaps even gold and other hard assets.

After working with thousands of investors over the years, I’ve found that each individual investor has a unique way of managing his portfolio… a unique outlook on return, risk, and other factors.

But most of us spend so much time focusing on stocks and other “traditional financial vehicles,” that the move into smart options trading gives us a little pause… And it most certainly should.

Derivatives & Smart Option Trading

That’s because options are indeed derivatives. And derivatives, in a sense, are not real investments… They are contractual rights that are “derived” from an underlying investment. As is the case with a stock option, it’s “derived” from an underlying stock.

When you buy a stock option, you don’t own a single share of a stock. The same goes for options on bonds, indexes, gold or any other security.

All derivatives - even ones so complex and risky, like interest-rate swaps, that we’d never consider them - are contracts. All you get when you buy an option is a set of rights.

This is a very important point. If you begin to think of your options as investments - instead of trades using contracts - you can run into trouble. I have seen people do it. They put too much money in options, forgetting that they have no actual securities in hand. Then they go on vacation and leave options open, sometimes to disastrous results.

The Four Options Truths… And How to Use Them

However, by keeping four key truths in mind, you can begin to harness the incredible power of options, safely - and for serious profits that stock-only traders will never even sniff.

  • You need a price target more than usual - Option contracts always specify a strike price. You need to hit it or come close to make money. With a stock, you have a real security, you can wait forever to be right, and every penny of gain is a real penny’s worth of profit. You don’t even have to have a firm target in mind with a stock - if it is simply going up, you are gaining. Expecting that with an option is a deadly error because…
  • Options expire. Not only do they become worthless if they don’t hit your strike price in time, the closer they get to that date, the faster they lose value. Because of this, you could be right about where the stock was headed and still lose money because it didn’t move fast enough.
  • You need to choose a definite direction. You have to decide whether you are expecting the security to go up or down by the time of expiration. That determines which kind of option you will buy or sell. With a stock, you can simply own it and do fine if the direction goes a bit against you. It might come back later. In fact, stocks on decent companies usually do. Or at least you can get out with a minor loss. With an option, it takes relatively little adverse movement to create big trouble.
  • You don’t get your money back if you are wrong. With a stock, if it drops, you can easily sell when it hits your trailing stop. With an option, you can also exit early - most of the time. But because of the leverage that magnifies moves, you have to act quickly to get out of a deteriorating situation. If you are too slow, you can see your option go to “no bid,” even if there’s still a lot of time left on the contract.

I’ve just listed a lot of risks… It’s enough to make a careful person think twice. And you should.

However, once you’ve gotten the lay of the land, starting with absorbing these four truths about options, not only will you be able to trade options for double-, or even triple-digit percentage gains - you can actually do it with a degree of safety that will let you sleep at night.

Good Trading,

Karim Rahemtulla

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