If you asked me that question 23 years ago, I would have probably posed the following question back to you as my answer…
“Do you have enough money to lose trading options?”
When I first started trading, I didn’t fully understand how options worked. I lost a lot of money.[ad#Google Adsense 336×280-IA]All I knew about options was that you could make a lot of money fast.
It’s a lesson we all learn at one point or another in life… There’s no free lunch, and when you hear “get rich quick,” it’s usually a great way to get poor quick!
No joke. I got sucked in, and it was one of the biggest mistakes I ever made.
But it was an invaluable learning experience.
Today, I’m going to tell you why.
It started with IBM. I made a trade on IBM using a normal call option. It was right before an earnings release, and Lou Gerstner had just taken the reigns as CEO.
The call trade was a slam dunk as far as I was concerned. IBM’s biggest changes in decades were taking place, and I knew that the quarterly report would project future optimism about the company, which had lost its way.
I made something like 300% overnight. It was a lot of money. In fact, my representative at Ceres Securities, now Ameritrade, even called me up to congratulate me on the big win.
So how is this trade one of the worst mistakes I ever made?
Throwing Caution to the Wind
It sucked me in. After that success, I thought I knew how options worked. I believed I was invincible.
That same year, I went on to lose more money in the options market than I ever thought possible.
When Tony Montana warned “don’t get high on your own supply” in the 1983 hit movie Scarface, he was right. I should have heeded his advice.
But it wasn’t until the following year that I really began paying attention to options strategies… not just options.
That’s what got me thinking about the age-old question: How much money do I need to trade options?
The answer varies, depending on the trading strategy you’re using. And when readers ask me this question today, I recommend thinking about it like this…
How much money do you need to live a great life? How about to afford your dream house? Or your dream car?
I can’t answer those questions for you, because every person has different expectations, risk tolerances and access to resources.
That being said, there are some useful guidelines you can use to determine the minimum amount of capital you should have at your disposal to get the most out of any options trade.
Let’s look at the most common strategies…
Covered Call Selling: In this case, you must own the underlying stock (at least 100 shares) in order to sell a covered call. You sell the option against the shares you own. You’d use this strategy to generate income. To generate a decent return, you need a trading account with at least $25,000 to $50,000.
Put Selling: When you sell a put option, you collect money upfront. This is your cash premium. You don’t spend any money at the outset. But, in order to execute the trade, you need cash or equity in an amount at least equal to 15% to 20% of the strike price multiplied by the number of shares in question. (This is your margin… See last week’s article for a refresher.)
One contract (minimum for a trade) controls 100 shares of the underlying stock. So if it’s a $30 strike price, and you sell one put option, you would need at least $450 (15% of $3,000) in your account to place the trade. However, most brokers will require at least $15,000 to $25,000 of cash or equity in your account before they allow you to sell puts. Why? Because if you get “put” the stock and have to buy shares, they’ll want to complete that transaction without having to chase you down for the money.
Buying a Call Option: This gives you the right (but not the obligation) to buy shares of an underlying company. Because it’s your right, rather than an obligation, your risk is limited to how much you pay for the call option. With this kind of trade, you’re betting on the upward movement of a company’s share price. The minimum trade is one contract, and most brokers would probably require only a few hundred dollars in your trading account.
It sounds simple, but this is the trade that got me in trouble! Why? Buying a call option is a bet, pure and simple. There are situations where this type of bet makes sense… and after decades of trading, I now understand how to use call options strategically. (In a future issue, I’ll go over those situations in-depth.)
Buying a Put Option: Much like buying a call option, buying a put option allows you to bet on the direction of a company’s share price without any obligation. Your losses are limited to what you paid for the option, but you’re making a big bet.
As I’ve written before, option buyers are least likely to succeed because time isn’t on their side. The cost of entry is low… You can buy put options as long as your account has just a few hundred dollars. But like a lottery ticket, the odds of winning are low too.
The belief that options trading is expensive and risky is a myth. As outlined above, you can trade options with as little as a couple hundred dollars, depending on the strategy.
I use option strategies as much as I use stock strategies. To me, there’s little difference if you know what you’re getting into.
I’ve had covered call positions that employed close to half a million dollars. And I’ve used my put selling strategy to buy 10,000 shares of stock at one time.
The opportunity, position size and risk-reward ratio should dictate your trade. You also MUST fully understand and be comfortable with the “worst-case scenario” before going in.
My advice? If you’ve never traded options, start really small, and get the feel for how a strategy works. When you’re comfortable (it may be months or years later), you can begin to use options more confidently to invest – rather than gamble… which is, unfortunately, what most people do.
Source: Wealthy Retirement