Options are a financial instrument that you can use for a number of different purposes: as protection against expected moves in an underlying instrument such as a stock; as a way to use leverage to control more of a stock than you want to buy outright; as a way to use your existing investments to earn additional cash; and many other uses. But, can you get rich trading options? The answer, unequivocally, is yes, you can get rich trading options. If you’re like most people reading this article, this is probably the answer you were hoping for.
The obvious next question then is, how can I get rich trading options?
Here’s what you could do if you have cash but not a lot of buying power: you could use all of your available cash to buy calls on your favorite growth stock with the expectation that the stock will absolutely skyrocket before your options expire, perhaps after next week’s earnings report. Since an option contract represents 100 shares of the underlying stock, you can profit from controlling a lot more shares of your favorite growth stock than you would if you were to purchase individual shares with the same amount of cash. When your chosen stock flies to the moon, sell your options for a massive profit. Rinse and repeat and before you know it, you will be buying that mansion you have had your eyes on since forever.
There are other ways as well. If you expect a company to declare bankruptcy, but no one else seems to know about it, then you can buy puts. When your expectation is realized and the underlying stock goes to zero (or close to it), sell the puts and pocket your winnings. Or, if you have a lot of buying power in your account, you can use it all to sell large numbers of naked puts on a company whose stock price you expect to be at or above the put’s strike price at expiration. The more volatile the underlying stock, the more the puts will sell for and the larger your gain will be. The key here is to use all of your buying power so that you win the maximum amount on each trade.
Use one or all of these strategies repeatedly until you are rich. Before you know it, you will be moving into that mansion by the lake that you have always had your eyes on. Easy, right? Well, maybe not so easy…
There is one element that each of these so-called strategies have in common: they are more akin to gambling than to trading. Unfortunately, just because something is possible doesn’t mean that it’s likely, or more importantly, that it is risk-free. In fact, if you are not careful, you are far more likely to go broke trading options than you are to get rich. There is a very good reason that the U.S Securities and Exchange Commission has qualification rules in place for investors who want to trade options as there is a lot of risk involved. They want to make sure you have enough investing or trading experience to hopefully make good decisions when it comes to options.
Does all this mean that you cannot get rich with options? Not at all. What it does mean, however, is that you are not likely to get rich fast or easily with options unless you are very lucky, but luck has no role to play in responsible stock or options trading. Neither does the word, “quickly.” Stop chasing that fantasy; you are unlikely to be successful unless you are willing to change your mindset and put a lot of time and effort in to your trading.
Three Ways to Help You Succeed
It turns out that the question we asked above about how to get rich with options is the wrong question. The real question you should be asking yourself is, how do I remove luck from my options trading? Or put another way, how do you reduce risk in trading options? To accomplish that, there are three interrelated things that I recommend you do.
First, throw out your crystal ball and educate yourself. Hone your skills with practice and study. No one can predict with 100% certainty the future price moves of an equity. What you can do however, is make an educated guess about the general direction of a stock’s price and about its floor or ceiling. You have to understand the company that you plan to trade and admittedly, that takes a lot of time and effort.
There are different ways to make educated predictions about a company’s stock price but a prerequisite to any strategy is understanding the company itself. What is the company’s product and who are its competitors? What is its market position? What are its strengths and weaknesses? Does it have a competitive moat that makes it difficult for new competitors to enter the market? Are there any significant risks? Who are the leaders and are they invested in the company or are they stringing it out?
Next, look to the future. Some traders use charts to help them gauge future price movements which means studying and learning chart patterns and how they pertain to the industry your chosen equity is in. How has the stock moved in the past in response to events such as earnings? While past performance is no guarantee of future results (sound familiar?), a lot of algorithmic trading programs make automatic decisions based on chart patterns and price movements so the charts can influence a stock’s price. This effect is likely more pronounced for short-term or event-driven movements and therefore might be more relevant to shorter-term options strategies.
Other traders use fundamental analysis to guide their future expectations. You should learn to read quarterly financial statements. You do not need to be a CPA or even take an accounting class, but you should at least know enough to get an idea of important factors like a company’s free cash flow, debt, margins, and so on. What you want is to get a fairly accurate idea of a company’s intrinsic value. In other words, what is a fair value, or price, for the company’s stock? There are other factors that influence a stock’s price such as sentiment, news stories and so on, but establishing a fair value provides you with some soft guardrails for the stock’s price.
Once you have a fair-value price, you can use an appropriate options strategy based on your level of acceptable risk. Instead of guessing or getting a “hot tip” from a friend or hyped-up website, use your own brain and knowledge to make reasonable estimates. (This is not to say that you have to do it all on your own; there are many reputable websites where knowledgable anaylysts discuss both charting and fundamentals. There are also a variety of tools available to help you be more efficient in your research, charting, and trading.)
The second thing you should do is understand risk, both generally for options trading as well as specifically for each trade you put on. Different options strategies have different risk profiles. Selling naked puts is riskier than buying long calls. With the former, you are on the hook to buy 100 shares of the underlying equity if the stock’s price is below your put’s strike price. For each contract, you are at risk for however much 100 shares costs at the strike price, minus the premium you received when you sold the contract. If the stock goes to zero, you lose the entire amount. On the other hand, the most you risk with a long call is the premium that you paid for it, so don’t spend more than you’re willing to lose. The bottom line is, know the risk profile of each strategy you use.
There is more to risk than simply how much you stand to lose on a single position, and the odds of that loss. You can think of that as positional risk, but you also need to factor in portfolio risk. Many options strategies, including selling naked options, require using buying power (or margin) in your account. Calculating buying power is beyond the scope of this article, but suffice it to say that if you over-extend your buying power and the market turns against your positions, you might face a margin call in which your brokerage sells your positions without your consent or participation. This is a worst-case scenario as it often means your stocks are sold out from under you at the worst possible time such as during a correction. When you use buying power, your entire portfolio is potentially at risk, so use caution and limit naked (short) options to a small portion of your overall options trading.
Finally, have a plan and stick to it; do not trade on emotion. This is likely the hardest element to master. Know ahead of time what your exit point is for each strategy and position. It is fine to adjust your fair-value estimates for your positions, especially the longer-term options where conditions might change. But don’t panic when your positions go negative for a day or a week or a month. Most options strategies can be rolled out or extended and if you did your research, you should be confident in your price expectation. If you managed and spread out your risk, then a few bad positions should not affect your overall long-term performance.
Also, be patient. By definition, options positions have an expiration date. Choosing that date is part of your research and is one of the factors in your plan. Try to avoid changing up the plan mid-stream unless there are very good, rational reasons for doing so. Getting excited or depressed because the position does not seem to be playing out the way you expected is neither rational nor a good reason to bail on the position. You do not need to look at multi-month positions every day. Check in once a week or so, but be patient. Give your positions time to play out, and when you are wrong, learn from it and apply your knowledge to your future positions. Over time you will get more experience and have more successful closed positions.
If you made it all the way to the end of this article, then congratulations. You might very well have the patience and diligence to get rich with options. It will probably take you years to accomplish, but with dedication and effort it is entirely possible to make a lot of money with options on top of your long-term investing.