Simplicity & Leverage.
Understanding and trading options.
Options are an incredibly simple concept with all the complexities that mankind can possibly add to them. For many, the simplicity is lost in the seas of complications and they end up losing money and failing on their journey. So let's break it down.
We use options in our everyday life. Most of us have insurance of some kind. Health, life, auto, home... What is the purpose of these insurance contracts? The purpose is to make us whole should some sort of big loss happen. We pay a premium each month for the right to be reimbursed or covered for something much larger.
This insurance contract is a put option. In the market, a put option doesn’t cover our car, but rather our stock. If we were to buy Apple stock, we could buy a put option to cover our losses should the stock plummet.
The put contract has a buyer and a seller, just like an insurance contract. I send my insurance company money, making me the buyer and the one who has rights. The insurance company accepts my money and takes on an obligation for a defined period of time. Put options are the same.
Call options differ in our analogy as those contracts ‘make us whole’ if the stock goes up rather than down. This can be a funny concept but since stocks can go up or down, we can insure them in both directions.
In the options world, we do not have to own the underlying stock to buy and sell these insurance or options contracts. These contracts are buyable with the click of a button and can be sold just as easy. Over 17 million options contracts are traded daily! And that number continues to grow.
Investopedia.com has some excellent sources on understanding calls and puts. We can highly recommend it!
Options allow us to make the gains of a stock for pennies on the dollar. This is the reason I trade options. I can lower my total dollar risk and increase my reward potential when compared to trading a stock.
Options give us the ability to bet on stocks going up or down without the massive capital requirements.
You betcha there are!
Each time we make a trade, we pay more to the broker than we would in a traditional stock trade.
With stocks, we can hold forever. We can wait for our price to come. With options, the value decays a little bit each day. In order to offset this decay we need to be able to ‘forecast’ a stock's price movement.
How do we succeed using options?
The TraderMinute Challenge harnesses randomness by looking at what can be controlled. We really cannot control much in the market, but what we do control is critical:
RISK — Each trader can control the amount of money they have at risk at any given time. Not just the risk on each trade, but the overall risk of their account. Having a handle on risk is paramount to success!
REWARD — What kind of return is likely for the risk that is being taken? Minimal risk for maximum reward is ideal! Many times there are close to sure things in the market that aren't of interest because the reward does not justify the risk.
EXPOSURE — Exposure is the overall dollar amount that might be allocated to a specific strategy. It's not wise to take all funds and dedicate them to one strategy in hopes that it works. Strategies go hot and cold all the time and there’s nothing worse than being overexposed to a strategy while it's cold.
And so we designed The Challenge to focus on the variables we can control and let it work for us!