You know what an option is and you believe that you understand how it works. Congratulations. But please demonstrate some patience before placing your money at risk. You are bursting with anticipation and cannot wait to begin raking in the money. However, it is not that easy. Money must be earned and please believe that no one gives it away. Here is a look at the pitfalls of buying options before you are ready to trade.
- Traders should carefully consider how option details like strike price, expiration date, and implied volatility will impact their potential profit (or loss).
- Beginners may be tempted to buy many different cheap, out-of-the-money (OTM) options, when they should instead pay more for fewer options that are closer to the strike price.
- Stocks don't trade in a vacuum, so don't lose sight of the broader market.
A Typical Example of Buying Call Options
Your favorite stock (FAVR) is currently $42.50 and you love its prospects. You just "know" that FAVR will be trading above $50 per share fairly soon. Based on that anticipation, you open a brokerage account and buy 10 FAVR call options. They expire in 90 days and are struck at $50 (i.e., the strike price is $50). You can hardly wait to see the money roll in.
So what happens? Most of the time expiration day arrives and the options become worthless. The once eager, new options trader (along with many experienced traders who should have known better), lost every penny invested.
The truly sad part is that your inclination was right on the money. FAVR did move higher, and 90 days after your option purchase, the market price was $46. The only problem is that you correctly predicted the price increase and still lost money. It is bad enough to lose when your prediction is wrong, but losing money when it is correct is a bad result. Yet, it happens all the time in the options world.
Unfortunately, this is a common result. So before buying options, please consider some things that you MUST understand about options. The purpose here is to make you aware of vital information. The details can wait until you have a better understanding of the basic concepts of options.
Earning a Profit
Many factors go into the price of an option. A trader cannot simply "buy calls" and expect to make money when the stock price rises. Much more is involved. The problem is that brand-new traders are unaware of all the other factors that affect whether the trade will earn a profit or lose money.
You expect the stock price to rise (i.e., you are bullish). Good. By how much do you expect the price to change? Is it reasonable - based on FAVR's price history - to expect the stock to move to $50 (an increase of almost 18%) in 90 days?
A history of the stock's average daily price change (volatility) provides a good clue to the correct answer. It is a poor strategy to buy (OTM) call options with a strike price of $50 if the average stock price move is $0.05 per day. However, it is a reasonable play when the average daily stock price change is $0.50 per day. Be aware of just how volatile the stock price has been in the past.
It is not necessary to buy OTM options, despite the fact that this is the choice of many traders. They believe their prediction will come true and they want to buy the cheapest options. Why? Our best guess is that most under-educated option traders want to own "a lot" of options, rather than just a few.
It is similar to the thought process that makes someone buy lottery tickets. The odds may be terrible, but the possibility of a huge payoff is too much to resist. Based on volatility data, buy options that have a good chance to be in the money at a later date (before the options expire). Thus, it would be reasonable to buy FAVR calls struct at $40, $42.5 (if these options exist) or $45.
Deciding how much to pay for options requires some trading experience. However, you must be aware of several items.
- Was the option price reasonable or was the implied volatility of this option too high?
- Did buying these options at this price give you a fair chance to make any money - based on your expectation for the price increase?
- Was the bid/ask spread too wide? Wide markets are more difficult to trade. Did you make the mistake of paying the asking price when you should always try to do better?
Holding Too Long
When buying options, do not plan on holding them until expiration arrives. Options are wasting assets and your plan should include getting out of the trade as soon as it becomes feasible. It is easy to fall in love with a profitable option trade and hold onto it, looking for a much larger profit.
Do not allow that to happen. Sometimes you earn the target profit. At other times it means giving up on the trade and selling the options while they still have value. If the stock price reaches your target (or gets near that target price), it is time to take your gains and sell the option.
The Stock Market
Was this a good time to make such a bullish play? Do you believe the stock market is headed higher? Most stocks do not move in a vacuum, and their rise and fall are dependent on the performance of other stocks. In other words, is the market bullish or bearish?
Did you consider all these factors? Did you consider any of them? The bottom line is that if you do not pay attention to each factor, then your chances of earning money become smaller, and the loss of your entire investment becomes the most likely result (especially when you purchase OTM options).
It is not enough to have a strong belief that the market will move higher or lower. When buying options, the option price has a large influence on the potential profitability of the trade and often matters more than a change in the price of the underlying stock. Thus, do not pay too much (based on implied volatility) for your options.
It is very important to recognize how easy it is to lose money when buying options. Most traders only think about "how much money can I earn?" Please avoid using options to gamble.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.