Selling versus Buying Options: A Risk / Reward Comparison

Next week I’ll be speaking at the MoneyShow in Las Vegas. It’s one of my favorite experiences every year. Not only is it a great opportunity to meet and talk to other options traders, but I also get a lot of really good questions at the event.

I decided that this year I’ll be more active in writing about the types of questions I receive. But the conference isn’t until next week, so for this article I want to cover two questions I’ve gotten often at past speaking events.

These questions typically come from those who don’t have a lot of experience trading options, which makes sense. However, there have been several times when I have gotten similar questions from those who have traded options in the past haven’t gotten a lot of guidance…

Common Question #1: I’ve heard options are risky. How can you trade options without losing lots of money?

I always get some kind of variation of this question. Traders who don’t trade options (and some that do) often feel that options are overly risky. Well, like any investment, they can be… but they certainly don’t have to be.

For instance, trading covered calls is a very low risk strategy. A covered call is when you buy a stock and sell a call against it to generate income. Historically speaking, covered calls are a lower risk strategy than a standard buy and hold strategy.

Just like any other type of trading, you want to go into options trading with a very good understanding of the product. Be sure you fully understand the risk and reward characteristics of any trade you make. If you do your research, you may find that using options is far better for your style of trading than using stocks.

Common Question #2: I’ve heard you should never buy options, only sell them. Is that true?

This question may be even more common than the first one, but it has a bit more involved answer. The fact is, you can make money buying options and selling options. There’s not a right or wrong answer, and it very much depends on how you prefer to trade.

Personally, I don’t only sell options or only buy options, but instead use a combination of both. It’s generally not a good idea to get shoehorned into just one type of trading strategy. The markets change, and you need to be able to adjust your strategy to keep pace.

In a nutshell, selling options is a higher probability strategy but the returns are a lot smaller per trade. Buying options is a low probability strategy than can result in really big returns. If you utilize both buying and selling, it’s easier to get to some sort of risk/reward tradeoff that suits your personal trading style.

If there’s one point that I try to convey more than anything else during my presentations, it’s that you need to have some kind of edge in how you trade. I’m not just talking about making money. Your edge is also how you trade to fit your lifestyle. If you aren’t enjoying trading or it doesn’t fit your personality, you won’t be a successful trader.

It’s extremely important to find that mix of return potential and risk tolerance which is a good fit for you as a person. If you can get to that point, you’ll have a much better chance of being a successful trader in the long-run.

Written by Jay Soloff, Investors Alley


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