Option trading for a newbie
- Thread starter Ben74
- Start date
Let's see, I am a retail trader, heck I barely had $12,000 when I started. The plays were puts or calls only so true. Nope there's no stops and my only hedge using like 10% of my account per trade.
So why not take the underlying? Well, let's see. If I had used $12,000 to buy JOYG at $16 on Tuesday. I buy about 600 shares. JOYG jumps to $18 the next morning and I'm out those 750 shares for a gain of about $1200. Not bad, but I learned one thing. What was my risk? My risk was basically $12,000. On the other hand, I only used $1,365 to control 600 shares of JOYG and as JOYG opened at $18, I was able to sell my options for a gain of $540. My risk here was no more than $1,365. Would sleep at night better with $12,000 at risk or $1,365 at risk?
I reckon we all sleep better knowing we can't lose more than $1,365 of our $12,000 account on this trade or any trade for that matter.
Ben
Your FSYS looks like it is going to show a good example why you dont use the underlining
Indeed, this is a very valid reason, thx... I don't do stocks, so I did not factor this in.
But, surely, we have to agree that, by definition, if you just play the delta, you must be able to replicate your option portfolio payout with the underlying (otherwise, you wouldn't be able to price options, 'cause Black-Scholes wouldn't hold). The only excessively strong assumption in BS is the absence of gaps (or, in fancy terms, mkt completeness), i.e. the assumption that you will always be able to hedge.
Let's do the math. Let's say you decide to risk 10% of your $12k account, i.e. $1.2k. You buy 270 shares at $16, with a stop at $11.56. Stock rallies $2 you make your $540; if your stop gets hit, you lose $1.2k.
So if you're buying options to deal with gap risk, that makes sense (if you sell options, it's a different story). If, on the other hand, there are no gaps, you can a) possibly lower your transaction costs; b) avoid taking risks that seem to be residual to you, such as vol moving the wrong direction.
Again, I am not an expert on how things work in the world of stocks, so this is good education for me. But I am intimately familiar with other option mkts and would use the logic above to make a choice between options and outright.
I think it all comes down to risk ratio. You bring out a good point of a set stop loss, and it's true that the stock could open the next day below the stop loss just like what FSYS might have done. On the other hand, I think it's more about risk ratio. I'm willing to risk $1,365 to try and grab up to $2,730 back for a 2:1 risk ratio. The question is how high does JOYG has to go before I hit my risk reward ratio. If I bought the shares like you said taking 270 shares at $16, I would need JOYG to reach $24.80 to get a $2400 return. In contrast, I only need JOYG to move to $19.50 before I get a $2,730 return in my options. At $24.80, my return would be about $5,800 or nearly double what the underlying would give me. Does that make sense?
Ben