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Trader Q&A: Why Trade Options?

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Randy Frederick:  All right. Well, let’s dive right in to this topic of options. It’s something that I’m passionate about. I’ve spent my almost entire 30 years of my career on this topic in some capacity. But what’s interesting is that if you look at the number of clients that we have at Schwab which is six million or so – it’s a huge number, the portion that trade options is still relatively small. So the question that often comes up is why should I even trade options. 

Randy Frederick: Very interesting. All right. Jeff, jump in. Why do you trade options?

Jeff Chiappetta:  Yeah, that question to me is loaded because you have 30 years of experience. Jim, you have 30 plus years of experience. I’m much younger and have only 25 years of experience but we all have the same passion about options and trading. For me, options, its really all about flexibility. Flexibility to, first you can generate monthly income by selling covered calls. Second, you can protect an individual stock, an entire portfolio even. And then third, you could speculate. That’s not something that we generally recommend to clients but speculation is – clients do that and options afford that opportunity as well.

Randy Frederick: One of the things I always say when I’m teaching clients about trading options is that I say I can teach you a lot of things. I’m not going to teach you how to speculate because you can learn how to lose money without my help basically. Right?

Jeff Chiappetta: Exactly. And I think we can talk a little bit more about mistakes that clients make. But I think one of the biggest mistakes that we typically see is the client that’s just starting out trading options, they start with speculative strategies.

Randy Frederick: Right.

Jeff Chiappetta: And when you hear the perception of oh, they’re very risky, that’s the reason why is because they’re starting with speculative strategies. So the more we can teach clients how to start with the basics, income producing strategies or even hedging strategies to me the better.

Randy Frederick:  Yeah. And Jim I know you’ve said this many times, that the intention of options initially was to generate income, was to provide hedges for adverse market movements, not really to speculate. But you kind of can’t have one without the other. And in fact, if you are using options for what we like to call the proper use which is to hedge, you have to have someone that you can sell your risk to, so there has to be a speculator on the other side. You can’t have a market unless you have a hedger on one side and a speculator on the other, right?

Jim Rouzan: When I first started, there was two of us making markets in options in this one particular stock many, many years ago. Now there’s 4,000 people making markets. Options are very liquid. They provide protection on your stock, on your portfolio. It is a great time to be trading options.

Jeff Chiappetta: I think too though going back to the flexibility even in IRA accounts now, clients can leverage options to take advantage of bullish strategies, bearish strategies and even neutral strategies too. All in IRA accounts and in addition to margin accounts.

Randy Frederick: Yeah. And I think that’s really – I’ll jump in here. The reason I enjoy trading options is because I like the fact that I’ve got so many different things that I can do with them. I always say look. When you buy stock if you like a stock you buy it and it goes up, you make money. If you don’t like it you can either stay out or short it. That’s pretty much it. There really isn’t any other choice.

But one of the things that I love doing and I know you guys do this as well is I like to do what we call selling time which is I can put on a strategy where I sell a covered call against a stock or maybe I sell a short put and then I just sit there and wait and the thing will actually work in my favor assuming there’s not a major move in the stock just because time is elapsing. That’s really not something that you can ever do with a stock. When you trade a stock whether it’s long or short, if that stock goes sideways you just can’t make money. But options give you the ability to make money even in a sideways market which I think is what I like best about options.

Jim Rouzan:  Agreed. That’s probably one of the best benefits. You buy stock. You’re bullish. You hope stock goes up. If it goes down, then you become an investor.  Most people can’t participate when the market goes down. You don’t participate in a bearish market. When it’s a bad market and no one knows what to do, you can buy puts. And the other best thing about options is you can be neutral. The market is doing nothing. I can sell a call spread, sell a put spread. You can put on a neutral strategy.

Randy Frederick: Yeah. And I would add one of the things I like best also about options is if I want to trade a really, really expensive stock, I mean there are stocks out there that are really popular that are trading for over $1,000.00 a share, some of them $1,500.00, $1,800.00. I mean it’s difficult to do a round about 100 shares of a stock like that because it’s a gigantic position. And unless you have a multimillion dollar account that you’re trading it in, it’s really tough to do that. But I could put a spread trade on it for a few hundred dollars like you said. I can participate in an upside move or a down side move and really never take on the kind of risk or have to be so heavily concentrated in that one stock which I think is really fascinating.

Jeff Chiappetta:  I agree Randy and I think – not to turn it into an infomercial up here for trading options but I mean if you’re looking for a conservative strategy and a way to generate income maybe two to three percent a year either on a portfolio or an individual position, covered calls can do that for you. And it’s not risky and it’s not difficult. It does take a little bit of time and attention. But it’s not hard.

Randy Frederick:   Well, we touched on this just a little bit about the concept that I think a lot of people who don’t really understand much about options, the first instinct they hear is that options are derivatives. Derivatives has a really bad connotation in today’s society especially since the meltdown of ’08. This was not the type of derivative that had anything to do with what happened, but it is part of that big broad category. And I think people who don’t really know a lot about options, their initial instinct is that it’s gambling. It’s too risky. How do you approach that kind of a question when you get it?

Jim Rouzan:   Wow. Well, the first thing I think of, whenever you buy an option you buy a call or put, the most you could lose is the price you paid. When you sell options, we do them in spreads. We negate the risk. You know how much risk, how much money you have to lose. I don’t like to have risk. I know you talk about having a trade plan. Risk is part of my trade plan. I know how much I want to lose. I know how much I want to make. I think what traders forget is how to lose money. I know exactly how much I could lose per trade. So I’m out when xyz is a certain price and move around to my next trade.

Jeff Chiappetta:  Yeah. So it’s really about risk defying strategies, right? There are speculative strategies that have unlimited risk. Just like if you short a stock, in theory there is unlimited risk. Now it never actually happens that way

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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction. Call Schwab at 800-435-4000 for a current copy.

Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

Past performance is no indication (or "guarantee") of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

The information presented does not consider your particular investment objectives or financial situation, and does not make personalized recommendations. Any opinions expressed herein are subject to change without notice. Supporting documentation for any claims or statistical information is available upon request.

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