Options Market Myths DeBunked: How to Handle Risk and Brokerages

by Karim Rahemtulla Wisdom of Wealth Wisdom of Wealth

Options Market Myths DeBunked: How to Handle Risk and Brokerages

by Karim Rahemtulla, Options Expert

Tuesday, June 29, 2010: Issue #1291

Alright, let's try to clear a few things up here...

In response to my article last week about selling put options, I received plenty of feedback and questions - most of which brought up options risk and the ability to actually trade options and sell puts in different accounts.

I want to tackle those issues in a public forum, shedding some light on the element of risk, plus the rules and regulations surrounding options trading and brokerages...

How to Handle the "Options Risk Myth"

Since options trading was introduced, the myths and misconceptions about them have been as common as the sunrise.

But let's play some "point/counter-point..."

  • Point: Many people believe options are risky. Riskier than stocks anyway. One of the chief reasons given for that risk is that options are time-sensitive. They have expiration dates. And that's often cited as a reason not to trade them.
  • Counter-Point: Sure, stocks don't expire. But they can still decline and lose you a lot more money than options. And when you consider that most people don't hold stocks for more than a few months at a time these days, you've just made the case for trading LEAPS (long-term options). LEAPS expire in one, two, or three years - a much longer period of time than most people hold stocks.

And after all, why tie up 100% of your capital and put it all at risk when you can achieve the same or better results with just 10% to 15% of your money at risk?

In truth, you're always going to have some risk when investing. So no matter whether you're trading options or any other investment, if you're doing so without a specific strategy or just for pure speculation, then of course it's going to be riskier.

When the Going Gets Tough... the Tough Get a New Broker

Now let's deal with how you actually go about trading options. This one is simple...

  • Point: You cannot make certain options trades in your account. Your broker won't let you.
  • Counter-Point: You can trade just about any type of options strategy in any account - be it a regular brokerage account or retirement. It depends on your level of options experience and the rules that the broker sets. Yep, the broker. Not Congress or the IRS.

There are brokers who will allow you to sell put options in your retirement account... execute covered call trades... spread trades, in addition to buying and normal options.

It's up to you to ask your broker for permission to make these trades in your account. Brokers like Interactive Corp, Think or Swim, Scotttrade, Ameritrade and Fidelity allow some or all of the trades that I recommend in retirement and non-retirement accounts.

The bottom-line is this: It's up to you to find the right broker for your needs. And if you don't ask your broker to allow you to trade options in your account, then you're hurting yourself. And if your broker says no, then get another broker.

Okay, so what about good and bad trades? And would I trade BP right now? Answers below...

The Pick of the Put-Sell Candidates

Investment U reader Sam R. sent in this question last week:

"I enjoy your comments. I'd appreciate if you could give examples of recent successes and failures of trades you've exercised. Will you use BP as a case for the put-sell strategy now?"

  • My answer: Sam, I trade a lot of options, for sure. Recently, when the market headed south for a few weeks, I executed a lot of  put-sell trades. The companies I traded were e-Bay (Nasdaq: EBAY), Microsoft (Nasdaq: MSFT), Intel (Nasdaq: INTC), iShares FTSE/Xinhua China 25 Index (NYSE: FXI), Wal-Mart (NYSE: WMT), General Electric (NYSE: GE), JP Morgan (NYSE: JPM), Berkshire Hathaway (NYSE: BRK-B)... and BP (NYSE: BP).

In all but one case, I sold put options on these stocks at strike prices that were 40% to 50% below the share price at the time. I don't think I'll get "put" on any of the trades (i.e. be obligated to buy the shares)... but if I do, I'll be a very happy camper.

With regard to BP, I sold put options on the stock there, too. Specifically, I sold the October $7.50 puts for $0.50 per contract. As you know from last week's put-selling article, this allows me to buy BP at $7.50 at options expiration in October.

Now, I don't think the shares will get there, but there's always a chance. And the only reason I was able to get $0.50 a contract at the $7.50 strike price (the latter of which was almost 70% below the share price at the time that I sold) was because of the huge uncertainty and volatility in BP shares. But I didn't sell a lot of contracts because I'm not interested in potentially owning a few thousand shares of a company like BP at that price. But I think that the odds are in my favor or I wouldn't have made the trade.

As for losers, they occur, too. I sold some Citigroup (NYSE: C) January 2011 $5 puts, which put my cost around $4.20 at expiration. Citi is currently trading around $4, but there's plenty of time to go on the trade yet.

For much more on the options market and how to execute the various strategies, take a look through our Investment U archives. I'm confident that you'll find they're not quite as scary, complex, or risky as some people would like you to believe.

Good investing,

Karim Rahemtulla

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