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Demystifying the World of Options

On the other hand, if you are a very short-term daytrader trying to capture incremental price changes, there are very few listed options that will provide sufficient liquidity or price movement to match trading in the underlying security. For this type of trader, using options offers little advantage over trading the stock.

In all situations, you should calculate the maximum potential risk, reward and break-evens before making a trade. This will help you choose what strategy is most appropriate, keep losses to a defined amount and hopefully help you achieve superior profits.

Calculating Returns

Calculating the returns on options is one of the most confusing and difficult aspects of determining the success and/or failure of a particular trade. For this reason, it is also ripe for abuse by people who want to shed the best light on their strategy and performance.

Be consistent with how you measure returns. If you measure losses in dollar terms, don't measure profits in percentage terms. This is important when comparing the risk/reward of buying options vs. owning stock. For example, if you own 100 shares of Yahoo! at $30 and the stock declines to $25, you lose $500, or 16%, whereas if you owned one $30 call for $2, the loss is only $200, but also 100% of your investment. Conversely, on the profit side the percentage return on the option is the more impressive number, and the one usually touted, rather than the dollar amount.

Another favorite tactic is for people to annualize the returns of short-term trades that are not repeatable over time. Don't do this. Many option positions have holding period of just days or weeks; to annualize the returns of such a short holding period is very misleading.

Even for ongoing income strategies such as covered calls, it is very common for people to extrapolate the returns of one month, if the stock stays still, to show the annualized returns. This is nice in theory, but in reality, stocks don't stand still and the returns can vary widely from month to month. There is no justification for annualizing the returns of time-specific, isolated trades.

The bottom line is that everyone must find their comfort zone and what works best for them. Only by understanding how options work can you determine if they have a place in your investment toolbox.

Want to learn more about options? Sign up for a free trial to my newsletter, TheStreet.com Options Report.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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