Jeff Clark's Market Minute

The Right Way to Speculate With Options

The average option trader loses money. That’s because the average option trader uses options the wrong way…

They use options for leverage – to get “more bang for the buck.”

The thinking is that instead of putting $10,000 into a stock that might go up 10%, 15%, or 20%, the trader puts $10,000 into a call option on the stock with the hopes of making 100%, 200%, or more.

It’s the thrill of making fast, triple-digit gains that attracts most people to option trading in the first place. But, while this sort of thinking might lead to a few big gains, it eventually causes enormous losses.

Traders blow up their accounts, lose a bunch of money, and then swear off options forever.

Don’t let that happen to you.

I’ve been trading options now for 36 years. And I can tell you, without any hesitation or doubt, if you want to make lots of money in the options market… then forget about the reward.

You need to focus on risk.

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Options are designed to reduce risk. So, anytime you’re buying an option, you should approach the trade with the objective of limiting the amount of money you can lose on the position.

Let me show you what I mean…

(This is not a recommendation. It is a trade example for illustrative purposes only.)

Let’s say you wanted to buy 100 shares of NVIDIA Corp. (NVDA) – the semiconductor company. NVDA traded yesterday at about $157.50 per share. So, 100 shares would require a $15,750 investment.

And let’s also say that you are willing to risk a 20% move in the wrong direction for your trade. In other words, if NVDA moves against you by 20%, you’ll stop out of the trade and limit your loss to $3,150.

Since that’s the most you’re willing to risk, there’s no need to put up $15,750 to buy NVDA shares. Instead, you can just take the $3,150 you were willing to lose, head to the options market, and buy some call options on NVDA.

Remember, though, we want to use options to reduce the risk we would otherwise have on a stock position. So let’s not use the full $3,150 we were willing to lose on the stock. Let’s cut it back to just $1,800 instead… limiting the maximum potential loss to about 60% of what you were willing to lose on the stock.

The NVDA March $157.50 calls closed yesterday at about $5.75. Since each option contract covers 100 shares, you can buy three contracts for $1,725. That gives you control of 300 shares of NVDA for $1,725, versus the 100 shares you would have bought with the $15,750.

Not only have you reduced the risk on this trade by 40%, but you’ve also increased the potential reward by controlling more shares.

This is the right way to speculate with call options.

Of course, if you’re wrong on this trade, you could lose 100% of your money. But it’s far better to lose 100% of $1,725 than to lose 20% of $15,750.

And if you’re right on this trade, you can make a lot more money by owning three call options than by buying 100 shares of the stock.

By buying the calls, you’re able to reduce your risk and increase your potential reward. So as long as you buy options with less than the amount you are willing to lose on the stock, buying calls or puts can set up a better trade than buying or shorting the underlying stock.

Best regards and good trading,

Jeff Clark

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