How to avoid blowing up your trading account using options
The wrong bet can potentially lead to infinite losses
Options are a great tool for investors who want to limit risk but can prove costly for those who don’t know how to use them properly, according to one market pro.
An option’s value is determined by a number of factors, including price, time to expiration and volatility, and investors who may be less tuned in to financial markets could be caught off guard by sudden shifts that result in the value of their purchase going to zero or even lower.
The “easiest way” to blow up your trading account is by selling naked options, according to Anthony Saliba, CEO of the Chicago-based Matrix Execution Group, an executing broker-dealer that specializes in options and equities, told FOX Business.
Selling a naked option gives traders an infinite amount of risk, since they don't yet own the linked security and might be forced to buy during a period of upheaval, while limiting their reward.
“The other way to blow through your capital is just to keep buying calls, rolling the dice for a big move, and not have it happen,” he said, noting that a lot of investors lose out to time decay. Buying a call or a put outright gives investors the right to buy or sell a stock at a given price by a specified date.
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Options trading has exploded in recent months as more investors have taken a personal interest in their investment decisions while sheltering at home during the COVID-19 pandemic.
Three of the five largest trading days by options contract volume came in June of this year, according to the Options Clearing Corporation. On June 11, a record 2.8 million one-lot orders were filled, evidence retail investors were getting into the game, according to Saliba.
The majority of option trades made by beginners are purchases that have finite risk and sales that have finite reward.
When investors buy an option, they have one chance to profit: A move in the direction they anticipated. They will lose money if the stock doesn't move or goes in the opposite direction.
When investors sell an option, they have two chances to make money: if the stocks sits or moves the way they expect. They lose if the stock does otherwise.
Therefore, Saliba believes investors should take the time to learn about spreads, which keep traders “insulated to a great degree from a sudden loss” while they are still getting comfortable with options.
As with anything, it's important to “get the proper education and training,” he said, noting that anyone interested in options should learn basic hockey-stick graphs of profit and loss outcomes, be familiar with volatility and most importantly, find a mentor.
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“Find that kind of a community, a chat room or a bulletin board or subReddit Group,” he said. “That really helps, to have one or two of them up while you're trading and get comfortable with one that you like. Eventually, you might even be contributing.”