You Don’t Need Complex Trading Strategies to Make Money
Warren Buffett once described options (and other derivatives) as “weapons of wealth destruction.” That’s because derivatives — investing tools that “derive” their price from the value of the stock or ETF that they’re based on — can carry great risk. More complex derivatives tend to have more risks, and with more complex trading strategies the risks are sometimes difficult to understand.
Take commissions, for instance. In the grand scheme of things, commissions on trades are small, and many traders ignore these costs when making investment decisions. But there are times when they should not be ignored.
For instance, when a strategy requires placing two or more orders at one time, commissions can add up quickly. Complex trading strategies often involve buying and selling multiple options and have interesting names like “iron condors” or “butterflies.”
Iron condors and butterflies promise low risk and a high probability of winning, although the maximum gain on the trade is usually small. In many cases, it would not even be enough to pay for the commissions and fees charged to enter the trade.
An iron condor requires buying two different options contracts and selling two other contracts. Selling options generates income to lower the cost of the ones you buy, allowing you to enter the trade at a lower cost. But traders will need to pay commissions on four different trades to open a position. With a butterfly, two different contracts are bought and a third one is sold, resulting in three trades and three commissions. You might also have to pay commissions to exit these trades.
Many traders argue these costs are insignificant because commissions on options might cost less than $1 per contract. When fees and minimum commissions are met, the cost might be $5 to $10 per position at the lowest-cost brokers.
However, consider this: One discount broker’s website explains that commissions could reduce trading profits by 48% or more, assuming you win on 75% of your trades. If you win less often, commissions could have an even greater impact.
That’s for basic strategies. Complex strategies can eat up even more profits. And it can be very difficult to find three or four options contracts that all offer significant potential. But it is possible to find great trades with minimal risk when you limit your search to a single option, such as buying a call option or selling a put option.
When you buy an option, you are buying the right to buy or sell 100 shares of a stock or ETF at a specific price within a specific amount of time. A call option gives buyers the right to buy the stock or ETF, while a put option gives buyers the right to sell. When you sell an option, you receives a payment upfront for taking on the obligation to buy (put option) or sell (call option) the stock or ETF at a specific price within a specific amount of time
If you believe that the release of the next iPhone will lead to an increase in the price of Apple (NASDAQ: AAPL), you could buy a call option that expires after the release date. One benefit of the call is that it would cost much less than the stock, perhaps 5%-10% of the price of AAPL shares. Given this lower cost, the percentage gain in the option could be much greater than that of the stock — another benefit of options.
When selling put options, the primary goal is to generate steady income, while the primary “risk” is that you will be assigned shares at a discount. I consider this a conservative, low-risk strategy, because more than 94% of put options expire worthless. That means put sellers profit more than 94% of the time, keeping the income they generated with no obligation to buy the stock. This puts the odds in your favor without identifying three other contracts on the same stock or ETF that offer potential rewards.
Conservative investors are right to be wary of complex options strategies and the high commissions they carry; however, they should consider simple options strategies as a way to derive profits for their portfolio.