Don't Allow Your Option Trades to Disappoint
Novice option traders tend to focus on a single option strategy. They purchase options and seldom consider selling them instead. There is sound reasoning. Selling options comes with greater risk — more money can be lost.
But newer traders come to the table understanding that there is an opportunity to turn a small investment into a much larger pile of cash. In other words, they like the idea of owning call options when bullish, and owning put options when bearish.
This can be a very profitable trading system for investors who have a proven track record that demonstrates skill when predicting market direction.
Unfortunately, most traders overestimate their ability to know when the market is moving higher or lower. It is far more difficult to find success with the option-buying strategy than the average trader realizes. Several important reasons prevent these newer option traders from making money.
Predicting Direction Is Difficult
Even the majority of professionals who manage other people's money can't outperform the market averages. Yet most individual traders believe that they can do better. With that optimism, they enter the options market with that optimism, expecting — or at least hoping — to find a new way to earn money from the stock market.
Predicting Market Direction Is Not Enough
This statement may seem to defy logic. One of the very first lessons option traders learn is that calls gain value when the price of the underlying stock increases — and that puts gain value when the stock price declines.
So it seems obvious that when you own calls and the stock price moves higher, you would surely earn a profit. While the call owner can profit under these conditions, it remains possible — even probable — that option owners will lose money even when the stock price moves in the hoped-for direction.
Choosing an Appropriate Expiration Date Is Crucial
Choosing an appropriate expiration date is a crucial part of the investment decision.
Even when you correctly predict a rally or decline in the stock price, timing is crucial. Many an option trader has bemoaned the fact that his option expired worthless before the anticipated change in the stock price occurred.
Options are wasting assets that lose money as time passes. This concept may be difficult to understand for someone who is only used to buying and selling stock. Stockholders have all the time in the world to hold onto an investment and wait for something wonderful to happen to the stock price, but option owners have a limited time as defined by the option's expiration date. When that time lapses, the option no longer exists. The trade may or may not be profitable when expiration arrives depending on the stock price, but the option owner has run out of time for this specific trade to work.
Buying Options With the Wrong Strike Price
Traders buy options with the wrong strike price. Often, the trade objective is to turn $100 into $500 or $1,000. That very tempting feeling convinces a novice trader that a large increase in the stock price is about to occur and that the best investment is to buy cheap options hoping that they will explode in value. Once in a while, that dream comes true.
But the truth is that cheap options are cheap for a reason, and the likelihood of seeing any of those juicy rewards is pretty small. The trader would be better served by a goal of turning $100 into $150, or even $200.
Those inexpensive options are always out of the money at the time the trader buys them. The hope is that they'll become in-the-money options as the stock price changes, but the truly inexpensive options are usually too far out of the money and tend to be money-losing investment vehicles.
Buying Options at Market Price
Inexperienced traders often buy options at the market price. In other words, they pay whatever price they are asked to pay. That is a very inefficient way to trade options and it significantly decreases any trader's chance to come out ahead in the game.
First, it's almost always best to try to buy options with a limit order rather than a market order.
Second, it's important to recognize whether options prices are reasonable, expensive or relatively inexpensive. This ability comes with experience and a further study of how implied volatility affects option prices. For now, the new option trader should just be aware that options are not always priced fairly. No one is trying to cheat you. Sometimes prices are quite high and it is better to be a seller rather than a buyer. At other times, the opposite is true and buyers have an edge over sellers.
Choosing an Option Strategy
Option strategies range from the very simple to extremely complex. Most traders learn a few basic strategies and never get involved with complicated positions that involve multiple options and frequent trades that allow the trader to mitigate risk. New traders should keep things fairly simple. There are basic methods that are appropriate for bullish, bearish, and market-neutral traders.
Reduce the Risk of Holding
It's a good idea to hedge — or reduce the risk of holding — a specific position when trading options. It's difficult to predict when to buy options and which options to buy for all the reasons mentioned above. The option trader reduces the cost by hedging and the maximum possible loss when the trade does not turn out as expected.
The trade-off for a hedged position is that potential profits are also limited. But make no mistake: Just because gains are capped, this does not mean that potential profits are tiny. It just means that they are no longer unlimited.
A spread is a hedged position in which a trader buys one option and sells another. Both options are calls, or both are puts. More complex spreads can be traded. You may well ask why trade a spread? Sure, you get the reduced risk aspect, but why would anyone be willing to place a limit on profits? Let's look at one bullish example:
- ABCD is currently $61 per share
- Buy five ABCD Dec. 16, 60 calls @ $3
- Sell five ABCD Dec. 16, 65 calls @ $1.20
- Net debit: $1.80 ($180) per spread, plus commissions
Sometimes we cannot determine whether the call being bought is reasonably priced, relatively cheap — this happens when implied volatility is too low — or expensive when the implied volatility is too high. By selling another call, you reduce the risk associated with paying an elevated price for options. This risk is known as volatility risk and it can be measured. Vega is the term used to describe this specific risk. Readers who already have some understanding of the Greeks know that buying one option and selling another is a standard method for reducing risk.
In general, when one option is overpriced, then all options on that same underlying stock — and with the same expiration — tend to be overpriced. If our purchase price for the December 60 calls is too high, we would be selling the December 65 calls at a price that is also too high. We'd recover a portion of the amount that we overpaid.
This is how a hedge works: You may pay more than the true theoretical value for one option, but you collect more than the true theoretical value of another option. The risk associated with paying too much for your option is therefore hedged or reduced by selling another option to create a spread.
Similarly, other risks associated with option trading can be reduced by trading spreads. For example, when you buy a call option, you take a bullish position that is equivalent to owning a quantity — less than 100 — of shares of the underlying stock. That share equivalency is measure by another Greek term: delta. By selling another call option, you sell out a portion of those deltas and own a position that is nearer to market neutral. It is still a long bullish position, but less so. This translates into a smaller potential profit and a reduced possible loss. In other words, the position is hedged.
When you own any option, its value declines day by day. That risk is measured by the Greek term theta. Selling another option offsets part of that time decay risk. Note that options lose theoretical value every day. If the stock price changes favorably, the option may gain in value for the day. It's important to recognize that the varying risks associated with option trading interact with each other. If your option gains value due to a change in the stock price, it may also gain or lose value due to a change in the implied volatility. Simultaneously, it will lose some value due to the passage of time.
It's not easy to know just how much the price of your options will change as market conditions change because so many different factors come into play. Much of the time, it is the stock price that plays the largest role in just how much money your position will earn or lose. But at other times, the novice trader is surprised by how the marketplace values his option position. Just be aware that factors other than stock price are in play.
It is important to learn about options in a systematic manner because you can't jump from one topic to another before understanding the basics. Demonstrate some patience and much of what you want to understand will become clear. You should refrain from trading with any significant money at risk until you're satisfied that you understand the concepts of how options are priced.