1. Don't invest money in the stock market that you know
you will need to spend.
2. Start slow.
3. Don't buy too little.
4. Don't buy too much.
5. How much should I spend on options?
6. Always use limit orders.
7. Minimize Commissions
8. Use tax advantaged accounts where appropriate
9. Don't use stop loss orders.
10. Have realistic expectations.
11. Have some fun.
12. Duplicating the BAILOUT portfolio.
13. Free Book on Options: Options-101
14. How to get started with options.
15. How to open a LONG option position (buy a call, buy a put)
16. How to close a LONG option position.
17. How to Sell, Write, Short an Option.
18. How to close a SHORT option position.
19. How to trade Spreads.
20. Trading other combinations.
21. What is automatic exercise?
22. Can I avoid automatic exercise?
23. How to exercise a long call.
24. How to exercise a long put.
25. I am long a call or a put, and don't want it exercised.
26. I am short a call, and don't want to sell my shares.
27. I am short a put and don't want to buy new shares.
1. Don't invest money in the stock market that you know you will need to spend.
True story: If you bought shares of New America Fund stock in 1972 for $9.22, you could have sold it in 1980 for $100 a share.
If you bought shares of Blue Chip Stamps around the same time for $7.50 a share, you would have stock worth $3,700 a share by the year 2000.
It's stories like these that make people eager to invest in the stock market. What is usually left out is the following:
Charlie Munger's fund, "Wheeler, Munger" invested in both of these stocks in 1972. The market crashed in 1973-1974, causing these holdings to lose about 60% of their value. Munger advised his clients to hang on and weather the storm, but one person, who had invested $350,000 right before the crash, pulled his money out - for an almost 60% loss. If he had held on, he would have made a huge amount of money. Munger didn't say why the guy pulled his money out, maybe he panicked, or maybe he had too.
There are a lot of lessons to be drawn from this little story, but the main one is:
If you know you will need to spend X dollars in Y months, don't invest it in the stock market. It might not be there when you need it. As painful as it may be to earn a meager return from a CD or savings account, you will at least have that money when your bills come due.
I am a big fan of starting slow, especially for beginners. Realize that you WILL make mistakes. If you keep at it, you WILL improve over time. Even the best investors make mistakes. Even experienced investors buy incrementally. Someone who wants to end up with a stock occupying 5% of their portfolio would perhaps make the purchase in two or three lots, possibly spread over a period of a year or more. This allows you to take advantage of better prices, should the stock go down.
As an inexperienced investor, you should buy even more incrementally :)
3. Don't buy too little.This is a common beginners mistake. You should start slow, but not too slow :)
Try to keep your total trading costs to 3% or 4% of your investment. There is a mathematical basis to this, but an illustration is probably more meaningful:
You buy a shares in ACME for $25. One year later, ACME stock is selling for $31. This is a 24% increase, which anyone with experience will tell you isn't all that common and is something to be celebrated. After all, if you could achieve a 24% increase in your invested capital every year, you would double your money pretty darn quick.
Let's say your commission charges are a flat fee of $8.95 for purchases and sales of up to 1,000 shares of stock. Since you will sell the stock eventually, the total trading cost is $17.90. Here's how your potential profits in ACME stack up relative to your purchase size:
| Shares Purchased | Commission % | Cash Profits | Percentage Profits |
|---|---|---|---|
| 1 | 72% | -$ 11.90 | -28% |
| 3 | 4% | $ 0.10 | 0% |
| 10 | 7% | $ 42.10 | 16% |
| 16 | 4.5% | $ 78.10 | 19% |
| 20 | 3.6% | $102.10 | 20% |
Note that 'trying it out' with just one to three shares will pretty much guarantee you a loss. You will need to buy 20 shares, at a cost of $517.90 (including commissions), to make a 20% return.
Here's another way to look at it. If you divide your total commission costs by the number of shares you bought, you get your 'commission per share'. Add this to the share price to get the actual amount you are paying for each share. The stock must advance to this price in order for you to break-even on your investment.
Using the prices above, if you buy four shares of stock, you've only spent $117.90. And your commission per share is 17.90/4 = 4.48. Add this to the $25 you spent to get the adjusted cost per share of $29.48. This means that your stock has to increase by 18% in order for you to get back to zero. This is a huge move. Even if you are a brand new investor, you must realize that the larger the percentage move, the more unlikely it is to occur.
Spending 517.90 to get 20 shares is spending a lot more money, but now your stock only has to increase by a bit more than 3% to get to the break-even zone. This is a lot more likely to occur.
Another related error is confusing the number of shares with the amount you invest. The amount you invest is the important thing - the number of shares is irrelevant. $500 will buy you 20 shares of a $25 stock, or $1,000 shares of a $0.50 stock.
On a related note, if you want to explore options strategies, you will need to buy in multiples of 100 shares.
As a general rule of thumb, keep each position to at most 5% of your portfolio. This would be considered to be a fairly concentrated portfolio by many. When you learn more, you will be able to adjust your position sizes better.
5. How much should I spend on options?
Number one rule: If your option trade involves selling a PUT, that means you might end up owning shares of stock in a company. So treat treat a PUT sale in the same way as you would a stock purchase.
If you are long CALLS, you do not need the same amount of cash, unless you are considering converting to shares.
Otherwise, for things like spreads, where you aren't necessarily interested in owning the stock, I advise not spending more than 1.5% of your investible cash on any one deal. Adjust this up or down as experience dictates, but remember that unlike stocks, options are wasting assets.
This bears repeating: Always use limit orders. This goes double for options trades. There is no shame in using a limit order for the current market price, if that's what you are willing to pay.
Finally: Always use limit orders.
Especially with options trades, a lot of brokers charge you lower commissions if you enter both arms of a multi-leg trade as one order. You can sometimes get better prices if you 'leg into the trade', but consider the effects of your commission prices on the 'legging' strategy.
8. Use Tax Advantaged Accounts where appropriate
Manage your portfolio as one big portfolio, but keep at least some of your trades in tax advantaged accounts (ROTH or Traditional IRA, SEP or something along these lines). Tax advantaged accounts have some trading restrictions - you can usually sell calls and puts, but spreads are pretty much out.
Tax advantaged accounts are especially nice to have for covered call strategies, or any option strategy (such as selling PUTS) that will net you income but not shares.
On the other hand, riskier, more speculative positions (both stock and options) should be held in an account where you can take the tax loss if they go against you.
9. Don't use stop loss orders.
With the possible exception of risky short positions, I don't advocate using stop loss orders. Peter Lynch has a wonderful passage in one of his books about the evils of using a stop loss order. I couldn't agree with him more.
Some of my biggest winners have had drops of 20% or more in one day, but over a period of 2-5 years, have gone on to double, triple, or even more. If I had used a stop loss order, I would have had to buy back in with (usually) an increased cost basis, a tax bill for the gain, and extra trading costs.
Stop loss orders are a lot like the United Nations. They seem like a good idea before you try it out, but once you've tried it....
10. Have realistic expectations.
Don't enter the market with the idea of turning your $1,000 into 1,000,000 in 2 years (or even 5 years). It is not going to happen, unless you are incredibly smart AND incredibly lucky. (Luck is more important in this scenario. Smart won't help so much.)
Warren Buffett's average return over his career is around 22% (depending on where you figure it). Peter Lynch clocks in around 16%. If you do this well, you are doing EXTREMELY well, and you should be proud of yourself.
People who enter the market hoping to make a dramatic short term killing are the ones most likely to make foolish investing moves by placing all of their money on a potentially huge winner (with potentially HUGE risks). Unfortunately, they never see the downside, which can represent 100% loss of capital.
Compare your returns to what you can earn without any risk at all. Risk-free investments include T-Bills, savings accounts, CDs, annuities. This is your bottom line 'hurdle rate', which you want to improve on with your activities in the market.
Investing is an interesting activity. You are participating in peoples hopes and dreams by buying part of their company. You can learn about things you never even heard of. Hunting around in company reports for clues to a wonderful (or disastrous) company can be a lot of fun as well - it gets to be more fun once you are over the initial learning stages.
Like anything, there are elements of pure drudgery to investing. Even ice skaters have to sharpen their skates and work out in gyms. But if you aren't getting *any* pleasure from the activity, you are unlikely to do well. Stop now and buy an index fund.
12. Duplicating the BAILOUT Portfolio.
You might just want to duplicate the stuff I recommend. Good luck to both of us if you do that :) There is actual cash behind every investment I make, but to make it easier to scale, the portfolio position sizes are based on a fixed cash amount of 1 million. So if you don't have 1 million to invest, but do have $100,000, you just divide everything by 10. $50,000 is probably the smallest amount at which it is practical to try to duplicate what I do Here, life gets a little more interesting. Invest some thought and effort to sort out the wheat kernels from the chaff I provide. This is all good.
If you find a particular recommendation particularly to your liking, you can 'dollar cost average' your purchases until you get the position size that you want. For example, every month, invest (say) $100 in shares of that particular stock. Some months you might get 10 shares, other months, you will only get 5. Over time, you will gradually build up a position at a lower cost basis.
This costs more in commissions, but if you are strapped for cash, there is not much choice. You can make money using this strategy, and I recommend it to you. I started investing doing exactly this, and I did very well, although it took a while.
Even though I resisted this for a long time, there were so many requests from readers for basic information on options and option strategies, that I finally caved in and wrote a book. It is available for free. Look for it here.
14. How to get started with options.
First you need to apply to your broker for permission to trade options. This is an SEC requirement. The details will vary from broker to broker. Some want you to fill out a form, others will be satisfied with a telephone interview. Brokers have "levels" of permissions, with each level supposedly allowing you 'riskier' trades. Typically, spreads will be allowed on level 2 (or level 3). This doesn't make much sense, since spreads can reduce your risk, but that's how it is. There is no consistency between what one broker will allow per level and what another one will allow. Try to get enough permissions to trade most spreads. Sometimes you have to stay at level one for a few months, and then you can apply again. The process is not particularly painful, but it's irksome.
Some accounts will not allow spreads, ever. These are typically retirement accounts, such as an IRA or ROTH. You can usually sell cash secured puts and sell covered calls. And these are very good strategies for an IRA.
15. How to opening a LONG option position (buy a call, buy a put)
To buy a PUT or CALL, you want to select "buy to open". You specify the number of contracts (remember that each contract controls at least 100 shares of the underlying stock). Always use limit orders.
16. How to close a LONG option position.
Select "sell to close". Use a limit order.
17. How to Sell, Write, Short an Option.
These are all synonyms. They all mean exactly the same thing.
To sell a CALL or a PUT, select "sell to open". Specify the number of contracts (remember each contract controls at least 100 shares of stock). Always use limit orders.
If you are selling PUTS, you will usually need to have enough cash in your account to handle the purchase of the shares. For example, selling an option with a $15 strike price may involve you in the purchase of $1,500 worth stock. For each PUT you sell, your broker will require you to have $1,500 in your account.
If you are selling CALLS, you want to sell them against stock you already own ("covered call") or as part of a spread, so that if the stock gets called, you are 'covered' by the ownership of the stock or a LONG call.
18. How to close a SHORT option position.
Select "buy to close". Use a limit order.
If you want to do a spread, it is generally advisable to enter both legs of the trade at one time. Most brokers (not all) allow this under something called "advanced options". Aside from often giving you better order execution, you usually save on commissions using this method.
When you place a spread order in this way, you don't specify each option price, you specify a net debit or credit amount. For example:
Simultaneously BUY a call and SELL a PUT.
The call costs $2.30.
The put pays $3.30
You'd be happy to get this order for $1.00 net credit. When executed, the broker might have bought your calls for $2.40, but then he would sell the PUTS for $3.40.
Reversing this:
Buy a PUT, sell a CALL
The PUT costs $3.30
The CALL pays $2.30
You will pay $1.00 net debit.
20. Trading other combinations.
The same comments apply here as in the answer to 19. You are better off entering things like rolls and buy/writes as one trade, if only to save on commissions costs.
21. What is automatic exercise?
If you are long a call or a put and it is in-the-money, even by a small amount, on the last trading day, it will be exercised automatically - even if your counterparty doesn't do it.
If you are long an in-the-money call, you will be buying shares.
If you are long an in-the-money put, you will be selling shares.
22. Can I avoid automatic exercise?
Yes. You must call your broker on the Thursday before the last trading day (which is always a Friday) to tell him you do not want the options exercised.
23. How to Exercise a Long Call.
You are long a call. It is in-the-money. At this point, you can call the person who sold you the option's shares away from them if you want. You must pay him the strike price of the option for each share (and there are usually 100 shares in an option contract). You will also pay your broker a commission.
The usual way to do this is to wait for the option to expire, when it will be exercised automatically. If you are in a hurry for some reason, the only way to exercise early (before expiration) is to call your broker and ask him to do it for you. There will undoubtedly be extra charges for this.
You can't exercise a short call. It's the buyers privilege, not the sellers.
24. How to Exercise a Long Put.
You are long a put. It is in-the-money. At this point, you can force the seller of the option to take your shares (100 per contract) for the strike price of the option. You will pay a commission to your broker.
The usual way to do this is to wait for the option to expire, when it will be exercised automatically. If you are in a hurry for some reason, the only way to exercise early (before expiration) is to call your broker and ask him to do it for you. There will undoubtedly be extra charges for this.
You can't exercise a short put. It's the buyers privilege, not the sellers.
25. I am long a call or a put, and I don't want it exercised.
This is only an issue of your call or put are in the money. If they are out of the money, is it a non-issue, as they won't be exercised.
You can sell the call or the put. This may or may not be possible. It is almost never a good idea to wait until the last trading day to take care of this.
You can call your broker and tell him not to exercise your shares. The last trading day of an option is always a Friday. Call them on Thursday. Many brokers won't accept calls like this on the last trading day.
26. I am short a call, and don't want to sell my shares.
If your call is in-the-money, buying back the call is your only recourse here. If it is out-of-the-money, this is a non-issue. It won't happen.
27. I am short a put and don't want to buy new shares.
If your put is in-the-money, buying back the put is your only recourse here. If it is out-of-the-money, this is a non-issue. It won't happen.