Most of us have seen the advertisements for options workshops. “Generate passive income using options!” It’s marketed as a safer and more conservative way of making money. Deceptively, the significant risks involved are not mentioned.
The Basics Of Income-Generating Options Strategies
An income-generating option strategy is simply one where you sell call or put options. There are other variations of this, such as selling spreads, or including the underlying stock. Here we will focus on selling options.
If you think a stock’s price cannot go below a certain level over the next month, say $10. You sell put options with the strike price of $10, and expiry of one month. It is like selling “insurance” to someone who wants to insure against the stock going below $10. When, and if the price is above $10, you pocket the entire premium that you sold the option for.
Workshops and articles typically label this a “conservative” approach. They highlight the benefits of making money even if the stock price trades sideways. While that is true, this strategy is better known to professionals as “picking pennies in front of a steamroller”.
Picking Pennies In Front Of A Steamroller
Put yourself in the shoes of an insurance agent. When your client makes a claim, the amount is usually much higher than the premium he paid. The same applies to selling options.
Your maximum profit is only limited to the premium you sell. So you need to repeat this process many times to make an overall decent return. On top of that, you are exposing yourself to the “limited profit, unlimited loss” payoff.
This means that if you wrongly estimate the stock price (below $10 in this case), you can possibly lose multiples of the premium you sold – ie. You can lose all your profits from many trades in just one trade. Next, your Profit & Loss can move very significantly before expiry. If you don’t understand the basics of options Greeks, you won’t know how much risk you are actually exposed to.
The danger is the reason why options come with warning: “You can lose more than your initial investment”. Since you are exposed to potentially unlimited losses, it is possible that you may end up owing your brokerage firm money. Although it happens rarely, it is important to recognize that it has happened to other before. It may happen to you too.
These strategies are not bad or useless – they are simply another way to speculate in the markets. The hard truth is many retail investors do not understand the risks involved. It would be wise to stay away until they do.
Read Also: Finance Dummies Series: Options (Part One)
Top Image Credit: DollarsAndSense.sg
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