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The following is a guest post by Kim Klaiman  @SteadyOptions_ 

Is Options Trading Really Risky?

There is a general misconception in the trading community that an option trading is very risky. Options can be risky, but they don’t have to be. Options can be less risky or more risky, depending on your risk tolerance. They can be used for speculation, but also for hedging, protection, leverage etc. There is more than one way to make money with options. Here are some of the common myths and misconceptions about options trading.

 

Myth #1: the only profitable way to trade options is buying calls or puts.

This is a very common misconception. While it is true that buying calls or puts can be very profitable, it is also a more risky way to trade. When you buy calls or puts, you have to be right three times:

  • Direction of the move.
  • Size of the move.
  • Timing of the move.

The underlying has to move in the right direction, and fast. You can predict the direction and the size of the move right, but if the move happens after the options expired, you lose money. Even if everything works in your favor, but Implied Volatility collapses (after earnings for example) you might still lose money.

 

Myth #2: you should aim for at least 100% gain in each option trade, otherwise it is not worth the risk.

Here are some questions you should ask:

  1. In order to make the 100%, how much do you risk?
  2. How much of your capital do you allocate for those positions?
  3. How much time do you give the trade to develop?

It might be better (and in some cases also less risky) to aim booking many 10-15% winners in short period of time (few days) than one 100% winner that takes 6 months to develop.

 

Myth #3: selling naked options is very risky.

Did you know that selling naked puts has the same P/L profile as selling covered calls? Yet most brokers allow traders to sell covered calls in their IRA accounts, but not naked puts? I find it extremely ignorant. An alarming number of financial professionals, including stockbrokers, financial planners and journalists are in position to educate the public about the many advantages to be gained from adopting naked put writing (and other option strategies), but fail to do so. Many public investors never bother to make the effort to learn about options once they hear negative statements from professional advisors.

Writing naked put options is a significantly more conservative strategy and definitely less risky than simply buying and owning stocks. As such it deserves to be considered as an attractive investment alternative by millions of investors.

 

Myth #4: Only take trades with a minimum of a 2:1 reward to risk ratio.

The truth is that risk/reward is directly related to probability of success. Typically, good risk/reward = low probability of success and bad risk/reward = high probability of success.

For example, when you sell a $10 wide credit spread for $1, you risk $9 to make $1, but such trade would usually have about 90% probability of success.

So next time someone will ask you: “Would you risk $9 to make $1?” – consider the context. Yes, it is a terrible risk/reward, but considering high probability of success, this is not such a bad trade. It will likely be a winner most of the time – the big question is what you do in those cases it goes against you?

At the same time, the answer to the question “Would you risk $1 to make $9?” is also not so obvious. It is an excellent risk/reward, but the probability to actually realize this reward is very low.

 

In trading, there is always a trade-off. You will have to choose between a good risk-reward and a high probability of success. You cannot have both.

 

Conclusions:

  • There is more than one way to trade options.
  • Position sizing is one of the most important elements of trading, especially options trading.
  • Few small winners achieved with low risk might be better that one big winner achieved with higher risk.
  • Selling naked options might be actually safer than trading a stock.
  • What is really important is not an occasional 500% winner, but an overall trading plan.

The key to success in options trading is using mix of diversified options trading strategies, like straddles, calendars, iron condors etc. In my opinion, you can rarely succeed in options trading by buying some cheap out of the money options and “hoping” for a big move.

 

Kim Klaiman is a full time Options Trader and founder of steadyoptions.com – options education and trade ideas, earnings trades and non-directional options strategies.

Read more from Kim on his Options Trading Blog.

Twitter: @SteadyOptions_