The Truth About Options Trading That The Gurus Never Told You | What Newbie Options Trader Must Know Before Getting Started

I started my options trading journey back in late Feb 2021. After more than 1.5 years of doing options trading and experiencing both the spectacular rise of the bull market in 2021 and the catastrophic fall of the bear market in 2022, I want to share some useful pointers to newbies who are tempted to try out options trading as a means to earn extra sideline/ passive income. And to offer a different view from what the dream that gurus have been trying to sell you that options trading is easy and relatively risk-free.

Read these articles for more context on my options trading journey:
1st Year Options Trading Recap: The Journey Towards SGD$217,509 Profits In 2021

What Is Worse Than Having A Portfolio With $618,800 (Unrealized) Loss?

Do You Understand The Basics?

Before starting options trading, do you understand the most basic fundamentals of options trading, such as how a CALL contract works or how a PUT contract works? If you do not understand, it is strongly advisable that you do not even start at all, because you will get into serious trouble by blinding executing orders based on the gurus’ recommendations or copying the gurus’ trades.

I have made a compilation of articles to help you understand the concept of options trading in this post below. It is written in a very simple manner with analogies for the layman and newbies to pick up the knowledge quickly.
The Newbie’s Guide To Options Trading

If you still do not understand after reading the articles a few times, it means you are not ready yet and it is okay, take your time to slowly learn if you really want to succeed in options trading. I have learned for more than 2 months by watching more than 2 hours of YouTube videos daily to grasp the concept before making my first trade in Feb 2021. It is better to get it right than to fall flat on your face when you get confused later.

Let’s Talk About The Safest Methods Of Options Trading

Before I explain the pros and cons of the simple options strategies, it is important to know that when you buy/ sell options, you are betting against the stock going in a certain direction and someone on the other side of the contract is doing the opposite bet. This means if you win and earn some premium, the person on the other side of the contract loses the premium he/ she paid when the contract is established.

Also, every contract consists of 100 shares. So, if you decide to buy a TESLA CALL option, you must be prepared that if the contract expires In-The-Money (in your favor), you will need to have enough funds in your account to buy 100 shares. Otherwise, your brokerage will liquidate (sell away) your other assets to buy the 100 shares that you have agreed to buy.

Unlike stocks where you will only profit when the share prices increase, in the options world, you can benefit too when the share prices drop. I wrote in this below article on the 4 ways how options trading can complement your investment portfolio:
4 Ways How Options Trading Can Complement Your Investment Portfolio

Let’s now discuss the 2 very common options strategies that many options traders, especially newbies, use: that is to sell cash-covered PUT or covered CALL. You can read further on why they are named this way in this article:
Why Are CALL and PUT Options Commonly Known As Covered CALL and Cash Secured PUT?

Buying Your Favourite Shares At A Discount (Through Selling Cash-Secured PUT)

When selling a cash-secured PUT options contract, it allows you to buy the stocks (100 shares) that you have always wanted at a discounted price because you are paid a premium for agreeing to buy the stock at X dollars if the price falls below X dollars at the end of the contract. Thus, with the premium collected, you are essentially paying for $X – premium per unit of share. As the gurus like to say, even the greatest investor Warren Buffet likes to use this method to buy shares at a cheaper price.

This sounds like a good idea, of getting a discount for a stock that you wish to own, provided the share price does not crash after you sell the PUT options contract. In the extreme scenario where the stock crashes after you sell the PUT contract, you will still need to honour the contract by buying at the agreed (strike) price upon expiry.

Let me give an example for better understanding. On March 18 this year, I sold an Nvidia PUT contract at a strike price of USD215. Back then, it was considered quite a bargain after the stock fell by more than USD100 from its all-time high of USD346. I received a premium of USD3.41 per share, which means that my breakeven pricing for Nvidia was USD211.59 (215 – 3.41). However, Nvidia’s share price continued to fall and the contract was exercised. At yesterday’s (2 Sept 22) closing price of USD136.47, the share price dropped a further 35.5%.

To be fair, the same thing could have happened if you have bought Nvidia shares on March 22 at around 200+ and you would have suffered the same % loss by now. However, the disadvantage of selling a PUT contract is the obligation to buy 100 shares when the contract is exercised. In another word, you need to buy Nvidia at USD215 instead of dollar-cost averaging into Nvidia as the share price dropped over the months. If I had bought 20 Nvidia shares respectively at $215, $180, $160, $140, $136, then my average price of 100 shares of Nvidia would be USD166.20 instead of USD215 (22.7% lower).

How About Earning Passive Income With Selling Covered CALL?

Selling covered CALL options against the shares that you already own is a relatively safe and popular options strategy and allow you to get some sideline/ passive income every month. There is seemingly nothing to lose as you get free money while selling at the agreed (strike) price that you are comfortable selling.

Similar to the selling of the PUT option, you have to sell away 100 units of your shares at your agreed price if the contract is exercised. This means that you are not able to sell them in batches and ride on the trend up, which may limit your upside if the stock price really shoots up exponentially.

The selling of covered CALL contracts complements the sell PUT strategy in the Wheel strategy, where the sell PUT contract gets exercised and the PUT seller now owns 100 shares which he can use to sell the covered CALL contract. However, if the share price of the underlying stocks fell to much lower than the breakeven share price, then there is minimal or no premium left to earn if the CALL seller chooses to sell at this breakeven price.

Using the Nvidia example, if my breakeven price is USD211 and I want to sell a monthly covered CALL at this pricing when the current share price is USD136, the premium is either 0 or close to it. There is a way of mitigating this by selling a long-dated covered CALL, but it also means that your stock will be locked in that contract and you cannot sell it during that period unless you decide to end the contract early. Selling covered CALL is a bearish bet, which means if the stock price keeps going up, it will take a higher premium to buy and close the contract, which resulted in a net loss.

How About I Buy CALL Options As A Form Of Leverage For Greater Returns?

The LEAPS CALL Strategy is a powerful strategy that can increase your return on investment by multiple folds when the underlying share price increases in your favor. It involves buying CALL options to lock in the price of the stock at a certain price and when the stock price rises, the option contract premium also increases, usually at a larger percentage growth as compared to the percentage growth of the underlying stock.

Whatever name it is given by the gurus out there, the LEAPS CALL strategy is an extremely powerful strategy when the stars are aligned and all things work in your favour. I made a lot of money in 2021 thanks to this strategy and in one particular trade, I had a 470% return in just a few weeks.

However, be very careful when the tide turns because you could end up with a huge loss and risk losing all the premiums you paid for the options contracts. There are 3 elements that can work against you and they are share price, time, and implied volatility.

As much as it can multiply your gains by a few folds, the LEAPS strategy can also multiply your loss by a few folds when the share price starts to drop. Time is always the enemy of options contract buyers because a part of the premium is paid to cover the duration of the contract. The longer the contract lapse, the less time value it has remaining in the contract. Usually, in the last 30 days, the time value decays exponentially. Lastly, when the implied volatility is high, the premium will be high and if it drops, the premium will drop too. Options contract buyers have the risk of losing premium value when the implied volatility drops.

Concluding Thoughts

The intent of writing this article is not to judge or criticize any options trading course or instructor or imply that options trading carries too much risk. I just wish to highlight the cons and downsides of options trading that newbie options traders may have overlooked, and in doing so, they can make a more informed decision and be aware of the risks involved. Options trading is a tool, like a knife, and depending on which side of the knife you hold, or how you use it, it can make a world of difference on whether you benefit from it or not.

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