Options Are Easy to Buy; Difficult to Sell

Protecting Profits

Stock market charts
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From a reader: 

"When I elect to buy single, out-of-the-money options, I lose money on most of my trades.  Often the options moved in-the-money (ITM) at some point, but I held on too long, hoping that they would move even farther ITM. Because of my greediness, I not only lost all the gains, but I also lost the premium that I paid - when the options expired worthless.

I make accurate predictions and still lost money. Options are not for me."

Unfortunately, this is a common situation. Traders lose money, blame options instead of their poor trading discipline, and abandon option trading. 

This is a difficult problem to solve because it requires that these traders adopt a different mindset. Instead of blaming "options" for their failure, they should be looking at two other factors:  

  • Choosing a specific option strategy.
  • Their ability to practice discipline while managing risk 


Options and Risk Management

Most people think of "risk management" in terms of being careful not to place too much money at risk at any given time. When trading options, that is accomplished by choosing an appropriate position size. And that is THE KEY to managing risk. However, experienced traders know that good risk management also involves cutting losses when trades go awry. But there is yet another aspect of sound risk management that is often ignored: protecting profits.

 

One way to get better results with profit protection is to begin each trade by writing a trading plan because it eliminates haphazard (random) decisions. When you believe that a stock price will be moving higher (or lower), it is easy to "just buy some calls" (or puts) and see what happens. That is not an acceptable plan for any trader.

 

First, important decisions must be made: Assuming that you prefer to buy options, which ones offer the best opportunity for making money -- based on your expectations for the stock price?  Which is the best strike price? Based on the timing of the expected price change, which is the best expiration date? What is your profit target? When you have no target profit, you lose sight of the reasons for making this trade in the first place. Then you have no idea when to exit. It is never viable to hold a position -- when the only reason is hoping to earn more money.

Thus, I say to our correspondent, part of your downfall is not greediness. It is the lack of a game plan.

OTM Options

The other major contributor to your losses is the fact that you buy out-of-the-money options. I understand that they are often inexpensive, allowing for the possibility of doubling or tripling your investment. However, the chances of any of these options moving into the money during their lifetimes are less than 50% (a good estimate of the true chance of an option moving ITM at any time during its lifetime is something that you can calculate from the option's delta).

If you truly find that your options "often" move ITM, then you are a skilled stock picker, and there is no reason to lose money on so many of your trades.

 

If you have a trading plan -- made before buying the options --, then you automatically have an exit plan. That plan will protect some of your earned profits. Sure, the plan can change as conditions warrant, but when you buy options with no plan, then (in my opinion) all further trade decisions are made randomly, rather than planned intelligently. And that is not the path towards earning money.