It’s funny how quickly attitudes can change. Just a few years ago, most casual investors wouldn’t touch stock
options with a 10-foot pole. Now the airwaves and Internet are clogged with offers to teach the secrets of “options investing.”
That kind of talk is just plain dangerous.
Despite my success with options, I would never be vain enough to call my work “investment advice.” When you’re dealing with options, you shouldn’t use the word “investment” at all. It’s speculating. And if you don’t understand the difference, you’re setting yourself up for a massive failure.
You “invest” in things like stocks, bonds, mutual funds, even real estate. You focus on the long-term. Successful investing is like planting acorns and watching them turn into oak trees.
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Speculating, on the other hand, is like playing with fireworks on a rainy winter’s evening. You light the fuse, and seconds later, it’s either fizzled out or a huge colorful explosion high up in the sky has illuminated the whole world.
It may sound like gambling. And for people who don’t know what they’re doing, it usually is. But smart traders know how to bend the odds in their favor. Doing that means having a healthy respect for a speculator’s best friend — and worst enemy — leverage.
Leverage is the magic that turns small price movements into large profits...or losses. It is found in many different guises, but the fundamental design is always the same. The leveraged speculator uses OPM (Other People’s Money) in an attempt to make more money than would otherwise be possible with nothing but his own funds. In other words, you augment your position with borrowed money.
It sounds dangerous...and if not managed prudently, it can be bad for your wealth. BUT, if leverage can be applied to situations with strictly limited risk, it takes on a more sensible aspect. It becomes...superleverage.
Superleverage is the art of profiting from changing prices, with limited risk. No margin calls, no demands for additional funds, no forced liquidations.
The instruments of superleverage are exchange-traded stock options.
Options are tradable contracts that give you the right to buy or sell a specific underlying instrument at a specific price within a set time period. Their value closely follows the ups and downs of the stock they cover…yet they usually sell for a fraction of the stock’s price.
That means a small move in the stock’s price can become a huge move in the option’s price.
On the downside, options are wasting assets. They have strict expiration dates. And if the underlying security doesn’t move enough to give you real value, your options will expire worthless. That is your risk.
It was once calculated that 90% of all options expire worthless. That doesn’t mean you have a 90% chance of losing money...a winning options trader will offset one or two spectacular winners against eight or nine losers...and still have money left over. The trick to always coming out ahead is to develop a strategy and stick to it.
My dad, legendary options trader Paul Sarnoff, explained it best: “Every trader with imagination and talent goes into a specific commodity armed with a trading plan.” With his help, I developed a system I call my Complete Game Plan for Trading Success. Followed correctly, it can be a powerful tool to make sure you don’t get in over your head.
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It starts with some simple calculations Just ask yourself the following questions before you risk a single cent:
1. How much am I willing to pay for the option?
As I said, you can lose 100% of the money you put into an option. So never bet more money than you can afford to lose. Once you’ve set your limit, stick to it. Don’t chase an option that’s more expensive than you want to pay. Either wait for the price to drop, or look for another one to buy.
2. What will I do if I’m right?
Have a profit target in mind for each option you buy, and an idea of how long the move will take. Be realistic — what you honestly think will happen, not what you hope will happen. (If you can’t do that, don’t buy the option.) Again, stick to your plan — give the option some time to reach your goal. If you meet your goal, sell right away.
3. When will I get out if I’m wrong?
This one’s tough. No one wants to admit they’re wrong. And everyone hopes they’ll eventually be proven right. But that’s where another benefit of options trading comes in — with options, you have always known and strictly limited risk. Or, said a different way, you never stand to lose more than you put up. If you invest in stocks, you may have to worry about where to set stop losses so that you don’t lose your fortune. But with options, your stop loss is already built in. They’re the only sensible way to speculate.
You should always speculate based on what you can lose, not what you can gain. Be prepared to handle trading losses. Never add to a losing position. That is how many players get knocked out of the game. You want to be in there when the market goes your way. You, or your broker, must monitor your positions closely. They don’t ring a bell when it’s time to get out, so make sure you have an exit strategy in place for each trade.
It may sound like a lot of work — but believe me, it’s worth it. I’ve seen options skyrocket 210% in three weeks…472% in less than a month…even 260% in eight days…
Of course, I’ve also seen a good number of trades go nowhere. But following the Complete Game Plan for Trading Success, the odds are good you’ll still come out ahead.
Just never make the mistake of thinking that you’re “investing.”
Sincerely,
Steve Sarnoff
P.S.:
To help get you started on your very own Complete Game Plan for Trading Success, I’m offering my next 24 explosive options recommendations absolutely free.
SOURCE:
HOWESTREET
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