There are times when the stock market is in a big, beautiful bubble. During those times, it’s difficult to convince anyone to sell, or bet against it.
Often, there is no hard evidence that a market is in a bubble until after it pops. That is why common sense goes out the window during bubble-euphoria as the market reaches levels that seemed impossible only a few weeks before.
Whether the U.S. stock market is now in a bubble or not will be for the history books. Regardless, one strategy that most traders (and investors) should learn is how to buy and sell options. Those who don’t understand options believe it’s “a sucker’s bet.” It definitely is if you don’t know what you are doing.
Although you can lose money trading options, many options strategies are designed to reduce risk and protect stock portfolios.
If you are willing to learn, buying options is an excellent way to participate in the market’s rise or fall, and with limited risk. This does not mean no risk. Although you can lose money trading options, many options strategies are designed to reduce risk and protect stock portfolios.
There are dozens of fancy-sounding option strategies, but all options are based on buying and selling “calls” and “puts.” If you believe a stock or index will go up in value, you would buy calls on that security. If the market is forming a bubble, typically there is a final melt-up that brings in the last of the nonbelievers. Owning call options during this stage can bring great profits if you’re able to get out before the reversal — easier said than done.
Now, if you believe a stock or index will go down in value, you would buy puts on that security.
The risks of options trading
Options have a bad reputation because people misuse them. Typically, investors underestimate how quickly option prices fluctuate and how easy it is to lose money.
Unlike with stocks, when buying calls or puts you have to be right about the direction and the timing of the underlying stock or index price. When you buy calls or puts, the clock is always ticking. If you’re wrong about the direction of the stock or index within a specified time period, you could lose most or all of your initial investment. That is why buying calls and puts are a speculative trading strategy, and not for everyone.
If you want to reduce risk, there are a variety of options strategies designed to protect stock portfolios. Buying puts is the simplest of those strategies. If you own a portfolio of stocks, you will lose a lot of money when the market plunges. By owning put options, you can offset all or part of that loss. If you own enough puts, you can even earn an overall profit when stocks decline.
Buying put options
If you believe the market or a stock has reached bubble levels, you might want to learn how to buy puts. If the stock or index drops in value within a certain time period, you make a profit. If it doesn’t, you lose money, perhaps the entire cost of buying the puts. You may already know that buying put options has been a losing trade for several years while buying call options has been a winner.
If you are convinced this market is going to plunge, I do not recommend shorting stocks. Shorting is a difficult skill for most traders to acquire, especially for beginners. Buying puts is less risky than shorting stocks. With shorting, your potential risk is unlimited. With put options, the most you can lose is the money you initially invested.
When you get a decent profit, sell. When you’re wrong, cut your losses quickly.
Five basic tips:
If you buy puts or calls, consider these five guidelines:
1. Start small. The key to buying calls and puts is to use less money to make more money. This is a rule that should be followed when you are starting out. At first, trade with no more than $1,000 or $2,000, that is, buy only one or two option contracts at a time.
2. Sell quickly. Unlike with stocks, option prices often move fast. You can’t buy a put (or call) and go on vacation, or even take the day off. When speculating with options, you need to concentrate. Options traders do not have the luxury of holding positions for long, so when you get a decent profit, sell. When you’re wrong, cut your losses quickly.
3. Learn slowly. It might take you at least a year to learn how to trade calls and puts. Consider that initial investment as tuition money as you learn what not to do, and to start developing strategies that work for you.
4. Focus on one stock or index at a time. At first, become an expert on the personality of only one stock or index. A good place to start is with is the S&P 500 ETF Trust SPY, -0.12% . You can spend years simply trading this actively traded security.
5. Make a trading diary. This is extremely important if you want to succeed as a trader. Keep track of your mistakes, the lessons you learned, and the trades you made. Keeping a trading diary is like having your own personal coach.
Michael Sincere (michaelsincere.com) is the author of “Understanding Options 2E” and “Understanding Stocks 2E.”