Saturday, July 15, 2006

Option Buying Principles

In my last article, I spoke about the limited risk (limited to the initial investment) and high leverage attained when buying options. Those can be fantastic plusses for the option trader. Astounding returns sometimes can be achieved but that possibility also can lead to some serious trading mistakes.

I trade for a living and sometimes teach various levels of stock and option trading seminars. In those capacities I have had the opportunity to watch many traders. These traders have had various levels of experience from novice to expert and ranged from successful to failures. Unfortunately, many traders lose, particularly those new to option trading. What factors cause traders to fail?

While this article isn't intended to be exhaustive, there are a number of recurring patterns I have seen in the trading of those who lose consistently. Of course, ANY trade has risk and can result in a loss. On any given day, there is a 50% chance a stock will go down and a 50% chance it will go up. However, that isn't what I'm talking about here. Unsuccessful traders often have unrealistic expectations. They see the possibility of huge returns and tend to think option trading is a way to "get rich quick." Rarely does that happen! If one is going to get rich trading options, it is going to require study, patience, and the application of sound trading principles. An option trader must not only know the adage "cut your losses and let your profits run," he must also know HOW to do that. The trader must realize that not every trade is going to be a winner. In fact, many trades may result in losses, but if the trader can make more on the winners than he loses on the losers, he profits.

So, my first 'rule' is to have reasonable expectations. If you make a trade that results in a 30% gain in a month is it reasonable to annualize it and say it is a 360% annualized return? Of course, that is mathematically correct, but is it a realistic expectation? Certainly not. While I have had trades that returned more than 100% or more in a short time, I do not have the expectation that they are going to occur all the time. I expect that there will be losing trades as well. Last year, for example, in trades I closed that were announced in our subscription service, 68% were winners. That means 32% were losers, but the critical fact is that I made a profit overall. Keep your expectations reasonable. If your expectations are unreasonably high, you may be disappointed and discouraged even if you do well. If you're disappointed and discouraged, your trading may well suffer. I once heard an excellent teacher say: "Worry about making good trades, the profits will take care of themselves." Remember, a good trade can even be one that suffers a loss. If a play turns against the trader and he exits appropriately, a loss will be suffered but a greater loss will have been avoided.

One of the glaring mistakes I have seen over and over with novice (and sometimes experienced) traders buying options is that they buy the wrong option. They buy the short term (less than 2 months) out of the money option. They think the options are cheap, I guess. They are cheap, but there are reasons they are cheap. Options expire. When a trader buys an out of the money option he is buying nothing but time. If the stock price doesn't move much and the volatility stays close to the same, the value of the option drops every day, and the closer to expiration, the faster it drops. The option will be worthless at expiration unless the stock moves in the direction the trader wants and that move must be made at least by expiration at the latest. If the trader didn't buy enough time for that to happen and holds on until expiration, he will have lost his entire investment! That could be true even if the trader was right on the direction, but the option just ran out of time before the move happened. It doesn't take long to run out of money (or patience) if the whole investment is lost in each trade. I believe that buying short term out of the money options can be a quick route to the poor house.

When I buy options, I know time is against me so I buy as much time as I can afford. That does not mean that I expect or intend to hold the option to expiration. On the contrary, I probably won't hold it that long. Buying the longer term option (at least 4 to 6 months out) means that time value is not running out as fast as it would in the shorter term option and gives the underlying stock more time to move.

I don't usually buy out of the money options and I rarely buy at the money options. The 'at the money option' is the one where we pay the most for time and since time runs out, I don't like to do that. My personal choice is often a longer term (6 months or more) 'in the money' option.

Another common problem I've seen is staying in a position too long. I don't remember ever holding an option I've bought to expiration. Before I ever enter a position, I know my initial exit. My exit is based on the stock price. If I know that initial exit before I ever enter the play, my loss will be cut almost automatically if the stock turns against me soon after I buy the option. Knowing and adhering to that preplanned exit is one important way to cut losses.

Though there are many other factors, having reasonable expectations, cutting losses by knowing the initial exit before buying an option, and refusing to buy short term out of the money options are three ways the average or below average trader may be able to improve his trading.

Bill Kraft, Editor
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Bill Kraft is the editor of the Option Trader Service at

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