The first thing people think when they hear “options trading”, is risk. Options are associated with risk because they can certainly be used to increase leverage. But they can also be used to decrease risk. In fact, options trading, if done correctly, can be done with less risk than futures contracts and at more favorable risk/reward payouts.
Think of options as fractional futures contracts. Any number of option combinations can be used to define exactly how much exposure you have in a market. If controlling risk is the primary focus, and it should be, then combining long and short options together, into one position, allows risk to be specifically defined.
Options can be traded with just a few thousand dollars, and options are not just for those with smaller brokerage accounts. Large accounts also use option spreads in the same way small accounts use them, positions are just larger.
Option Spread vs. Futures contract
A soybean call option spread can be used to trade soybeans to the upside rather than buying a soybean futures contract. The benefits are reduced margin requirements, less risk and, possibly, a wider range of profitability.
Risk to buy Soybean Futures contracts at 2% of $500,000 = $10,000
Risk to buy 1 Soybean call option spread at 2% of $5,000 account = $100
The max loss on this spread is $100 with a max profit of $500. But here’s where things get interesting – rather than look at taking the max loss or profit, look at various probabilities of price reaching specified profit targets to trigger an exit.
In this sample call spread, there’s a 50% chance soybeans will increase 4.3% which would make the spread worth $137.50 to $400. The increase in value will depend on when that level is reached, how many days before option expiration, but no matter when it happens, why not just exit based on the favorable 50% occurrence?
In other words, trade the probabilities instead of price.
Traded in this way, the risk/reward payout falls somewhere between .37 to 1 and 3 to 1. On 100 trades just like this we can average the risk/reward to 1.68 to 1.
Option spreads like these can produce tremendous expected payouts. And these returns are made possible by playing the probabilities rather than trading dollars or market direction!
It only takes a few thousand dollars to trade a diverse portfolio using option spreads. Properly traded, option spreads offer the best risk/reward trades available, so regardless of your account size, you should consider trading them anyway.
I will be showing many more specific option spread trades in the coming weeks so stay tuned. Sign Up for notifications and I’ll send you an email each time one is posted.
