Options trading is a tool that investors use when they expect their market predictions to be accurate without a doubt. Seeing that options are risky, the investor will either gain significantly or lose more money than they have. So, can options put you in debt?
Options can put you in debt very quickly. Inexperienced traders should avoid options and consider building another trading strategy. However, some experienced investors have found success using options, and their methods can be copied to prevent financial loss.
In this article, we will go over what trading options are and when to use them. We will also discuss how trading options can put you in debt. Additionally, we will show you how to use options to your advantage.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Are Trading Options?
Options refer to a contractual agreement between the buyer and seller of a share. This agreement gives the person buying the option the option (not obligation) to buy or sell a stock before its expiration date.
Regarding the European stock market, traders can only execute options on the day of their expiration. Trading options are available in two forms: call options and put options. Between these two, the investor has four choices:
- Buy puts
- Sell puts
- Buy calls
- Sell calls
Call Options
A call option gives the buyer the right to buy a stock at the strike price. For the most part, call options occur when an investor is confident that a stock’s price will move. You will buy a call when you think the price will rise and sell a call if you think it will decrease.
Calls should be avoided, particularly in a bearish market, because long-term calls become riskier in a market experiencing price drops.
Put Options
In contrast to call options, put options give investors the right to sell a stock at a specified price. You should buy a put option when you expect prices to drop and sell a put option if you anticipate a price rise. Put options work best in a declining market. However, if the share you placed the option on appreciates, your losses could be limitless.
What Are Options Used for in Trading?
Options have their place in trading and should be used in two instances only:
- Hedging to reduce trading risks
- Well-researched speculation
Hedging is a method investors use to secure their investments. It involves using options as insurance on already owned stocks.
To correctly hedge, you must purchase a share in a company and then use an option to protect against financial losses. For example, after buying a stock, you can place a put option to reduce the risk of losses later on. This is one means of hedging in the stock market. Please note that options do not have to be fulfilled. Therefore, hedging is usually not risky, but it can be.
Another reason why investors use options is to profit from their guesses. If research confirms that a stock’s price will increase or decrease, the trader can use an option to guarantee profits in either case.
The most significant feature of options is that they give you the luxury of capitalizing on your research without the necessary capital. If you guess the price direction correctly, you can profit ten times from only investing a few dollars.
When using options, you must remember that they are ultimately loans. Regardless of your winnings or losses, loans come with interest and much more risk.
How Can Options Put You in Debt?
With options, you can lose more money than you invested in short amounts of time due to the market’s volatility. The best research cannot fully predict a stock’s future, and your finances will suffer if the share makes an unexpected price change. This is how most people end up in debt when trading options, even experienced investors.
In addition to this, traders make other mistakes with options that often end up in a loss.
Selling Naked Calls
A naked call occurs when a trader sells a share that they do not own. Only some brokers allow this activity.
In exceptional cases, the broker will allow the trader to borrow money to fulfill their naked call. There are fees associated with this that the seller will have to pay. In addition to this, if the naked call fails, the buyer must return the loan and its interest and fulfill any other expenses generated by that loss.
If the price falls too low, the options seller must buy the share at the predetermined price, often leading to them spending more than their investment. Naked calls can also put you in limitless debt because there is no ceiling on your losses.
However, this is specific to call options. While put options are also risky, they limit your losses better than a naked call can. As a general rule, avoid naked calls unless you have superb risk management skills.
Trading Options That Can’t Be Turned Into Cash
Options selected from an illiquid market are guaranteed to land the investor in debt. The main reason for this is that the share cannot produce profits due to a lack of demand. Therefore, the investor will have a hard time making money from the option.
To estimate the share’s liquidity, divide the closing price for one day by the price range from high to low. Use the full trading day to gather these numbers. Afterward, inspect the numbers to conclude how well that particular stock trades on any given day.
The CFA Institute recommends this method for calculating liquidity because it gives the most accurate evaluation possible, helping investors evade monetary losses.
Not Knowing How Leverage Works
Most beginners do not fully understand how leverage works. Therefore, new traders will take advantage of the leverage that options offer without knowing that this drastically increases their risk. When leverage is misused, the interest can exceed the returns, leading to a net loss.
Using Options Without Putting You in Debt
There are ways to safely use options and not lose any money outside of your initial investment. The most obvious way to reduce the risk associated with options is to invest with on-hand capital.
Interest rates on loans are the most significant setback of profits. If you can avoid getting a loan to secure an option, do so. There are also hedging strategies, like covered calls and marrying puts, that you can use to reduce risks and even gain a profit.
Covered Calls
For options, Investopedia strongly recommends using a covered call. Covered calls generate income from the sale of already owned shares. To execute this strategy, traders buy shares then sell call options on stocks from that same company that equal the amount they already own.
Covered calls are most suitable for investors who already have stocks in their portfolio which they plan on holding for years. Also, it is best to choose a short-term expiration date for this option.
Marrying Puts
A married put is best for low-volatility stocks. This trading strategy involves the trader buying a put option from a company where they own shares. In doing this, the buyer limits losses by being granted the option to sell at a set price, regardless of the share’s depreciation.
If you suspect that a stock will experience a massive price drop, use this strategy so you can make a profit if it does.
Author’s Recommendations: Top Trading and Investment Resources To Consider
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Conclusion
There are many ways to avoid debt with options. However, it’s more likely that any options strategy will result in a loss.
Suppose you have weighed the consequences of options and still decide to include them in your trading. In that case, Sky View Trading has a video that all levels of investors can use to make the right decisions with options:
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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