Options Trading: How to Begin

Your First Conversation on Options

The businessman who confirms the stock prices
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I had the following conversation with a man who is approaching retirement age. He is considering using of options as a tool for increasing the income stream in his retirement account.

The conversation is worth sharing because it covers ideas on how to get started using options intelligently and conservatively.

Hi Mark,

I have been sifting through the vast array of information out on the Internet and your site and commentary brought it all down to reality. And I thank you for that valuable resource

I am 59 years old and want to learn how to take advantage of options in my retirement account. It is called an RSP in Canada and is similar to an IRA in the US. I also want to learn how to generate an income source using options.

I manage my own RSP account which consists of 100% equities. My on-line broker is great but does not provide a paper trading platform for options.

So Mark,

  1. Are my expectations realistic?
    Although you did not mention any expectations other than to earn some additional income and manage the account by yourself, the answer is yes -- you can do both of those things as long as your financial expectations are reasonable.

    If the stocks in your portfolio have listed options (and the vast majority of quality stocks do), and if you own at least 100 shares of any single stock, then you can consider adopting an easy-to-understand strategy: writing covered calls. In essence, you would be paid a cash premium (the good news), but in return would have to sacrifice any profits (the not-so-good news) if the stock price were to be above a previously agreed-upon level (strike price) at the time that the options expire. 

    There is more to it, but  you can think of it as collecting an extra dividend when you sell to another investor the right to buy your shares at that strike price, no matter how much higher the stock price may soar. That right exists for a limited time.

    There are other strategies to consider, but it is too soon to be thinking about those because your first task is to learn how options work and decide whether using them is suitable for your investment objectives.

  1. I wondered if there is a paper trading platform that does not require a real account to be opened. 
    Some American brokers allow paper trading - if you OPEN an account - but they do not require you to deposit any cash in the account.  If that is not appealing, try this: http://www.cboe.com/tradtool/virtualtrade.aspx   It is the CBOE (Chicago Board Options Exchange) version of a paper-trading tool. I have not used it, so do not know how well it works.

    I am a big fan of using virtual trading to gain experience with decision-making situations. Although some options strategies are very simple, the intelligent investor learns how to manage risk and how to "fix" a position that has gone awry. Thus, paper-trading provides two benefits: First it allows you to choose a strategy and construct a suitable position -- one that uses options -- to own. Next, it provides an opportunity to gain experience in deciding how long to hold onto the position (it is seldom a good idea to hold, waiting for the options to expire), and when to exit, accepting a loss or locking in a profit. 

    When you feel comfortable with the various decisions that you will have to make as an option trader, that is the time to fund your account and begin trading on a small scale.

    Note: Almost all the time your decision will be to "do nothing" and continue to hold the position as it currently exists. However, each open position must eventually be closed, either by making a trade to exist or because the option's expiration date has arrived. Thus, you should expect to trade more often that you do now, but it will not resemble 'active trading.'

    I am a complete novice! The little knowledge I have acquired has been during the past week.
    For the moment it is important that you demonstrate patience. Your primary objective -- at this time -- is to gain an education and then decide whether to proceed. 

    Read about how investors use options; learn what makes options unique in the investment world; discover how you can adopt option strategies that help you meet your investment objectives.

    Options are too often used as by speculators. However, based on your e-mail, I assume (hope) that you are not so inclined.

    It is best to search for option strategies that coincide with your market outlook (I assume that outlook is bullish because you are 100% invested in equities). You also want to trade with an acceptable reward (what can be gained by using options) and risk (what is sacrificed by using option strategies).

    Whether you decide to adopt an option strategy or not, your current job is to learn about, and understand, what covered call writing is (own 100 shares, sell one call option) and why you may want to use that strategy.

    It is important to understand that the basic income-producing methods come with the same risk you currently have --  if the market takes a big dive, you should expect to lose money -- just as any investor who owns stocks) -- but you will lose less.

    Plus, there is an additional risk: If the market surges, you will earn less than you would have earned because these strategies limit profit potential. To me, this is acceptable. I want an increased income stream and am willing to limit my upside to generate that income. But some traders are not willing to think that way.

    When you are comfortable after paper-trading for awhile, then begin to make real trades. Start small and work with more of your assets only after you are sure that you truly understand what you are doing. Take a look at these articles now (one, two, three) for some background, but come back to them later because they are not designed to TEACH you how to use the strategy.

    I wonder if considering options (for improving my portfolio and generating income in a separate investment account) at this stage of my life would be prudent.  That's what I meant by "my expectation" (mentioned earlier). It's a very general statement, I admit. 

    If you are currently "prudent" -- if you bought equities that a prudent investor would choose, and if you are not gambling in an effort to earn spectacular returns -- and if you are very comfortable (i.e., can easily sleep at night) holding the equities that you own -- then using options to add income to your portfolio is indeed prudent.

    However, if you elect to use options with the anticipation of earning a substantial return on your investment (perhaps 25% per year) or if trading options makes you uncomfortable, then it is neither reasonable nor prudent for you to use them. It is a very personal decision. 

    Being uncomfortable with your investments leads to much unhappiness unless the investor gets very lucky. Thus, take the time to be certain that it is something you want to do. I am not offering this conservative advice because trading options is too risky - but because if you have doubts, if you keep wondering if you are doing the right thing - then I would recommend taking more time to think about (and practice) using options before getting started. However, if you understand what using options offers -- in terms of potential benefits and risk -- and if using options still appeals to you -- then go for it. It is not risky. What makes option trading risky for some people is that they use options with no real understanding of what may happen to the value of their investment portfolio.

    Thank you for all the tips you have offered.  
    It is my pleasure, but keep in mind that tips are designed for people who understand how to use options and are not designed to turn a novice into a star trader.

    Please let me know if you are available in any capacity (on the web) with respect to disseminating options knowledge. 

    There are many ways to help others learn about options -- and some are more effective than others. If you like my writing style, read The Rookies Guide to Options, 2nd edition -- paperback or e-book -- and use the blog for supplemental information and explanations. Obviously, there are other books and other authors, and some are excellent.

    If you make it your goal to UNDERSTAND, then you will be able to decide whether options are for you. If your goal is to just make extra money -- without much effort -- then maybe you will succeed and maybe you won't. Options are not difficult to understand, but sometimes people adopt what appear to be low-risk methods, but get financially hurt by trading too much position size. Although there is no reason to believe that you will find "options" difficult, it remains a fact that some people are just terrible with arithmetic, logic, discipline, and they lack the patience to take baby steps.

    To play the game of using options to increase earnings (similar to collecting extra, good-sized dividends), you must be willing to accept limits on how much you can earn from your stocks. In other words, if you are a fantastic stock picker and find stocks that always outperform the market averages, then you can probably earn more from capital gains than you can by increasing your income stream. Or if you are someone who is greedy -- always seeking the maximum possible return, then limited profits may prove to be too difficult for your psyche to handle. 

    I suggest not opening a separate account just for your "extra income" strategy. It is far more efficient to work with your current equity portfolio -- and adopting an income-producing method with some of your stocks. 

    If you decide that a more advanced strategy would be better for you and your needs, that is okay. But please, do not trade that strategy until you are sure that you understand at least one of the basic strategies (covered calls, naked puts, collars). By the way, collars are not for you unless you are quite wealthy and primarily want to protect assets, rather than earn more.