Leverage Your Options Investments

Leverage Your Options Investments
by Ken Trester 08/26/08

For every great trade, there's the "one that got away" -- and probably more than one. Even professional traders take enough hard knocks to earn themselves a concussion, so to help you prevent cranial injury, let's talk about how much money you should be allocating to your options trades.

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Sometimes options can be priced just right ... other times, they can seem cheap. Yet, in other situations, they can be trading at a steep premium. When market volatility (which is a measure of the fluctuation in the market price of the underlying security) is touching its highs, beware the trap of paying too much for overpriced options.

WHY DO OPTION PRICES CHANGE SO MUCH?

When volatility spikes, option premiums climb right alongside it. But then when we see a pullback in volatility, it's similar to buying an item at full price and seeing it go on sale a week later. It just takes a little adjustment to volatility to whack down the option's price (even when the underlying stock doesn't move all that much).

The lesson here is to not invest too much money into one trade. Options, by their very nature, are short-term investments that allow you to control a lot of stock (100 shares per options contract) at a small price. These calculated tools can provide immense leverage, but leverage can work both ways! Make sure to never risk more in an option trade than you would be OK with losing completely.

Some investors get carried away with options, amazed at how inexpensive they are versus outright owning the underlying stock. Although options can cost anywhere from a few cents to more than your average stock price, depending on how high the shares are trading, I like to place my bets on options that are trading in the $1 (or, $100 per contract) range. That way, if they go up to $4, then I've just made a 300% return on my investment. But if the trade doesn't go in my favor, the most I can lose on the trade is the $1 that I originally risked.