What is the best way to start trading stock options?

October 3, 2012 10:11 PM

Thinking of stepping foot into Stock Options trading while in college full-time. Any advice on where to start?

Im currently pursuing a degree in Industrial Engineering at a college and want to get into Stocks as a side thing. I work part time and also have financial support from my parents(rent, tuition, etc) so what I make from work is basically my pocket money. I have been thinking about stepping into Stock Options trading. I have a friend who does that and he does really well. He has given me few insights on how things work. Anyways, I was wondering if anyone have any advice on where to start.

My intention is not to become millionaire or anything by trading stocks but just to have stable side income to make living.

posted by Parh6512 to Work & Money (10 answers total)

My intention is not to become millionaire or anything by trading stocks but just to have stable side income to make living.

Don't.

I mean, really, don't do this. Everyone has some friend who made money day trading, or playing online poker, or betting on the ponies, or whatever. It's almost always a terrible idea. You may be able to make money at it for a short while, but you will lose.

If there was a way to make a living doing it, rest assured that there are people with a lot more financial acumen than you, and a lot more free time than you have as a full-time student, who would be extracting all the profit out of it that exists. You are playing against them. Stock speculation (as opposed to buy-and-hold investment) is a zero-sum game over the short term; you can only win when someone else loses, and most of the other players have far more resources than you will, and far lower costs when they execute trades.

But of course, I doubt you'll heed this, because few retail 'investors' (really, speculators) do; most people assume that they will somehow be one of the lucky ones. It is irrational, and it is why the phrase "retail is stupid" is a cliche. But investors are loath to tell others about their losses, but only too happy to tell everyone about their gains, leading to a decidedly rosy picture of various high-risk strategies.

So if you really feel the need to do this, do two things first: (1) create a 'paper portfolio', using Excel or whatever other tool you choose, and execute the trades that you would do in real life, only without actually doing them. Take into account all commissions, fees, etc. from the broker you would actually use; no cheating. See if you are actually in the black at the end of six months. If you aren't disciplined enough to do this (especially the no cheating part), you have no business actually doing it for real. Compare the returns to what you would have gotten by putting the same amount of capital into the S&P 500 or some other standard equities-holding vehicle, and in particular look at the risk-adjusted return from each (again, if you can't calculate that, you are deep in children-with-matches territory). Going back and doing this retroactively, by the way, doesn't count; that's cheating by default. Any idiot can show a profit in retrospect, you have to actually do it in real-time for a while to demonstrate anything.

(2) If you really think you can hold your own against the big boys, set aside some money and go ahead and play if you must. Use absolutely no more than you can afford to lose. That is, no more than your disposable income over a few months. Do not risk your savings, defer payments into retirement accounts, defer debt payments, etc. (This should go without saying but, if you have outstanding loans of any type, you are not in a place to get into high-risk speculation.) You should view it the same way you would the money you'd take into a casino or the track. (The losses to fees from active trading as a retail investor can easily approach the 'take' and 'breakage' in standard pari-mutual betting, so the two are not as dissimilar as they might seem.)

I've known a number of people over the years who have gotten bitten by the options-trading bug. At first, particularly to those with only a casual understanding of how things work, it seems like an incredible opportunity for profit. But that profit potential only exists because of the leverage involved in the options, and is counterbalanced by a potential for loss: TANSTAAFL. If you do not have a fairly intimate understanding of how options work (and how the various parties involved make money), you should do nothing else until you have gained it.

IMO, the only way to actually make money engaging in short-term speculation as a retail investor is if you regularly have access to information or understanding that the market at large doesn't have access to, or misprices in some crucial way. E.g., if you had deep insight into some particular market segment and knew that a particular company was over/under-priced, then options might provide you significant leverage with which to take advantage of that position. So you should ask yourself: do you really have access to that sort of information? If you don't, then you cannot beat the house in this particular game for very long.
posted by Kadin2048 at 10:55 PM on October 3, 2012 [15 favorites]

The best place to start is the best place to stop: before you turn on the computer. I've been hearing stories for years about people beating the market. It's because there's a simple social bias: people don't talk about failures. That's the same reason why it seems you hear more often about people winning in Vegas then losing.

Listen, do you really think you can outsmart the traders out there who have 20-30 years of experience? Do you really think you can outsmart the PhD "quants" who are hired to write algorithms to eek out just another 0.1% annual return? Do you really think you can outsmart the supercomputers that do instant trades?

Please do not play with your dear parents hard-earned money. It's not your money that you would be playing with. If they weren't supporting your basic living expenses, the money you earn would all go to those expenses. So really it is their money. Please don't waste it. There are no shortcuts to accumulating capital unless you are extremely lucky or a criminal. Everyone else has to slog it out with hard work over long periods of time. Do your parents and yourself a favor and "get" that concept right now.
posted by Dansaman at 10:57 PM on October 3, 2012 [1 favorite]

Read this book. Take his advice and imitate his approach. Don't try to play the market, just invest the money as carefully as possible.

Or just save it. Interest rates are terrible right now, but compound interest is still a beautiful thing.
posted by The Master and Margarita Mix at 11:18 PM on October 3, 2012

I would heed the above advice (especially Kadin2048). However, if you want to see what option trading is like, Investopedia has a decent free stock simulator that has the full options array. You can dabble with that, and if you're still certain you can win, then your next step is to find a broker that allows you to trade options. Usually, you have to jump through some hoops before they let you do that, and I believe most require a minimum balance. So you'll have to accrue some cash first as a cushion.
posted by spiderskull at 12:01 AM on October 4, 2012 [3 favorites]

I'm going to skip the "this is a bad idea lecture" and give you the mechanics of how to do it. There are a couple of prerequisites here.

1. You should have a good basic working knowledge of the stock market. By basic working knowledge, I mean have actually executed some trades, ideally in the hundreds. Many option trading strategies hinge on simultaneously buying or selling the underlying stock at the same time. The bid/ask spread and cost of making trades can eat up a lot of theoretical profit.

2. You should have a good grasp of the strategies for trading options. My favorite book on the subject is McMillan's Options as a Strategic Investment. CBOE offers some courses in option trading.

3. You should recognize that most investors using options are using them as a portion of their portfolio (in the same way that you might also have a percentage of your portfolio dedicated to fixed income).

4. Option trading isn't designed for entry level trading, so you need a relatively large amount of working capital. Think in terms of $25K to $50K. Options are sold in units of 100 (a contract) and the commissions are relatively higher than trading the underlying stocks. If you are planning to do a lot of trading, you'll want to shop around for a brokerage that specializes in options. Because many of the strategies also involve doing something with the underlying stock, there are commissions there as well. For example, I might want to buy a certain stock and then sell a covered call against it. Because everything in the options market is happening in units of 100, the smallest trade there I could do would be to buy 100 shares and then sell a contract (the call). If the stock is trading at around $50 a share, that is a $5,000 trade right there. And for the trade to fully play out in my hypothetical example, you'll end up with several commissions: buying the stock, selling the contract, and, if the option gets executed by your buyer, selling the stock if they exercise the option.

5. Be realistic about what "doing well" means. Markets tend to be pretty efficient, because any inefficiencies will be ruthlessly exploited by traders until everyone piles in and the inefficiency disappears. With the rise of program trading, "everyone piles in" might be measured in (literally) milliseconds; not only are you trading against a bunch of smart veteran traders out there, but also against computer programs. A typical historical return in the U.S. stock markets is about 10% (e.g. you go and buy an S&P 500 index fund or something similar). Someone like Warren Buffett or George Soros are guys who can consistently get a 25% return over time, year after year. I would call a 15% return wildly successful. Because of the "friction" in trading options (inefficiencies like bid/ask spreads, light or non-existent volume on the option chains you are interested in buying/selling, and all of the commissions), you might find that the costs of executing trades are eating up all of your profits. Your trades might all be reasonable ideas, but when actually executed, you find that your actual return on investment is much lower.

6. I found that there was about a year long learning curve to basically make all of the rookie trading mistakes and learn from them. Since trades have a natural life cycle based on the options expiration date, I don't know that this is something that you can accelerate by trading more often.

7. The first time you have a trade idea work out really well and see a large return on investment (e.g. you see something like a 20% or 50% return on an individual trade over a short time period like weeks or months), you'll start to think, "this is easy, if I could just do this N times a year..." See point #6 about rookie mistakes.

8. I would recommend trading on paper for a few months before committing any actual money. Keep a notebook of your trading ideas and see how they would have played out. Use a spreadsheet to track your "paper portfolio" and be sure to include commissions. Again, because of the natural durations of option contracts, this exercise would also take some time to play out to see how your ideas would have worked out.

9. Stay away from leveraged option strategies (this is where all of the people up thread are saying "it is just gambling"). Your broker will make you sign a waiver to even do the basic things like covered calls and covered puts. Stay away from just buying contracts (buying calls) without an underlying strategy; you are just placing a bet on the underlying stock moving up within the expiration date of your option. It is a fun and exciting way of investing, but at that point you really are doing the equivalent of betting on a horse race.

10. Keep a detailed journal of all of your trades and be ruthlessly honest about tracking your real return on investment. If you are making a lot of trades and there are lots of ups and downs but you are generally seeing the needle on your trading account go up, it is easy to convince your self that you are "doing well". Your benchmark is the S&P 500. If you aren't at least beating that, then why bother trading? You might as well just put your money in an index fund.

Got all of that? If any of my advice doesn't make sense or I'm using jargon, just bookmark my post here, do #2 and #8, and then come back and reread it. Option trading is to stock trading what chess is to checkers. There are more layers of abstraction and a lot of underlying math to understand, so it takes some patience to really wrap your head around all of the concepts. Good luck, and don't forget to study for your day job as a college student.
posted by kovacs at 12:24 AM on October 4, 2012 [7 favorites]

If you have a stock you like, buy it and sell covered calls. Intend to hold the underlying position. It's lower risk, puts you in the market, gives you some downside protection for your underlying position, and is kind of 'free money' many investors forego. It's the easiest trading to get approval for as a newbie.

There are strategies that you can employ that hedge your risk and limit your upside/downside reward/punishment, but jumping right in to complex financials presumes you know more than you probably do.

If you can't pick a good stock, picking a good option isn't easier. That IE degree you are pursuing isn't heavy on MBA stuff, I am betting.

It requires a lot of attention, too. One screw up and you are at zero, fast.

Lastly, you have to be 'approved' by a brokerage and your chosen one may limit what you're allowed to do. To do some trades, like puts, you may have to have enough cash to buy the underlying at the strike price. That means it's sitting in your account.

If you are in the market, prepare yourself to lose money. If you aren't, prepare yourself to lose value. Interest rates are basically zero now. The best investment IMO is something that you can use to generate local revenue. Early in your career, investments in things that will make you stand out to employers is smarter, IMO.
posted by FauxScot at 2:18 AM on October 4, 2012

From a MeFite who would prefer to remain anonymous:

Hi, I'm a programmer at a trading firm. People at Goldman Sachs have told me that my trading firm is considered very good at what it does. What I've learned from the traders at my firm is that they are very, very good at their jobs and they have several advantages which are not available to you. Briefly:

- Your strategies actually have to be more profitable than the professionals' because you will pay more to execute them. One example: Every exchange I know has a different fee schedule for individual investors than for market-makers and broker-dealers. Usually there are discounts or rebates or some other form of payment offered to MM/BDs for providing liquidity. Another: unless you have an operations/post-trade department you haven't mentioned, you'll need to go through a broker-dealer, who will nail you with fees that the professionals don't have to pay.

- Even if you execute only good trades (positive expectancy), you will lose money, and the professionals have a lot more to lose than you. You may say think, "Oh, but I won't execute big trades." Except lots of trades actually have unbounded risk. If you write a call on stock you don't own, and the counterparty exercises it, you're on the hook to deliver that stock at whatever it costs. You can do a one-dollar trade and be on the hook for a million dollars. This is a very obvious example; there are more subtle ones, and even professionals can't always tell the difference.

- The first few years of a trader's career is a matter of buying experience with money (through making mistakes), and that's a process where you're disadvantaged in two ways. First of all, because professionals just have more money than you. And second of all, because they get to cheat by learning from the mistakes already made by their colleagues. (This is not the same as reading some forum on the internet or studying someone's newsletter. If that guy knew what he was talking about, he'd go execute the trades himself.)

There are lots more, but I have to go to work now. The bottom line is, don't do it. Kadin2048 seems to know what he's talking about; listen to him. So does kovacs, but he's not as strongly discouraging so I'd rather you didn't read him.

FauxScot, I'm sorry to say, doesn't sound like he's offering you very informed advice. For one thing, MBAs don't learn anything about trading. For another, covered calls are a stock joke in trading: hugely popular with the retail crowd, but not actually a sensible idea at all. The founder of my firm has told sad, head-shaking stories about how he's had to dissuade his friends from buying into some quack's covered call strategy.

If you really want to do this, use your engineering program to take lots of statistics, and then go interview at a few good trading firm. If you can't get an offer, that's their way of saying, "We really want you go to on the market, but not with our money."

posted by jessamyn at 6:59 AM on October 4, 2012 [6 favorites]

I strongly suggest a few addition's to kadin2048's paper trading suggestion.

1) Track the hours spent making and supporting those paper trades. You could use an application like RescueTime to help identify the hours in question. If you're watching Bloomberg or CNBC, reading WSJ, reading Finance/Investing books or blogs, taking Finance classes, that's all time you're investing. Track it.

2) Multiply the amount of capital you can reasonably commit by the EXCESS return (above the S&P) you can reasonably expect.

3) Compute your hourly rate.

As an example, if you have $100,000, and your evidence causes you to believe that you can beat the market by 10% annually, you're looking at $10,000/yr. And if you spend 2 hours per day doing that, you're looking at an hourly rate of about $13.70, or roughly what a first-year Apple sales clerk makes.

At some point it should become fairly clear that you can do far greater things for your long-term wealth by spending your time developing your professional network and skills than you can by doing options trading. Trading has a second deleterious effect, in that it spreads your focus away from things that will help you earn money over the long-haul.
posted by grudgebgon at 8:02 AM on October 4, 2012 [1 favorite]

Read "The Big Investment Lie" before you go anywhere near the financial markets.
posted by Dansaman at 9:18 AM on October 4, 2012

OP, I reiterate (as a techie and MBA) that covered call options are a good, low risk strategy for you if you want to be an owner of a particular underlying position. Properly used, they can enhance returns and slightly moderate risk.

The late anonymous poster is mistaken and much of his particular response is based on second hand info and frankly, excessively negative misinformation. His strengths may be in programming, but they are not apparently in finance.

Options aren't bad. They are like any other investment in that they have certain characteristics and risks. Understanding them is key to employing them well. Misunderstanding can cost you big.

I can't take the time presently to punch holes in anon's response, but will happily do so if you'd like to email me. I have been doing options as an informed investor for more than 30 years and have both scars and winnings from my efforts. Frankly, I've lost more on stocks than options, though I've made much more on stocks than options and am well in the black on both.

This is in response to your question of "HOW", as opposed to "IF". (Anon apparently thinks you are asking for permission. )

On the "IF" part, I truly think your money is best employed elsewhere, but if you determined to experiment with options, it's up to you to get informed as to how/when/what/why to use specific strategies.
posted by FauxScot at 7:41 AM on October 6, 2012