CATEGORY: FOR THE OPTION NEWBIEIt seems natural to buy options. After all, isn't that why they exist? The answer is no. Options were created to shift risk from the risk avoider to the risk taker. They were not created as a tool for speculators, although speculators play an important role in the options world.
It is important to understand that all investing has a certain resemblance to gambling. However, investors gamble only when they make trades based on too little information or when the trades are based on ‘hoping’ that something specific will come to pass.
I discourage gambling with options and I hope to encourage you to adopt a similar attitude. Nevertheless, it is convenient to use gambling vernacular when discussing certain aspects of trading.
T than trading stocks. When buying a call option, the investor (or trader) Is making a bet that the underlying asset (usually a stock, but it may also be an ETF (exchange-traded fund), index, currency, commodity etc.
Will move higher or lower before the option expires. Under most circumstances, it is a bad bet.
These are the primary reasons:
DIRECTION. Although most investors/traders believe they have the skill to know when the market will move higher or lower in the future, there is a ton of evidence that says just the opposite. For example, studies show that most individual investors under-perform the market averages, year after year. This is more a result of buying and selling at the wrong time, rather than of owning the wrong stocks. No matter the reason, the average active investor does worse, on average, than those who tend to buy and hold. Much of the poor results can be blamed on buying when everyone’ is bullish (near the market top) and selling when traders dump stocks in a panic (near the bottom).
Another study shows that most investors perform far worse than they believe they do. This seems strange, but perhaps this finding can be blamed on a poor memory. More than likely it is a result of traders remembering good results while tending to forget their worst trades.
If you believe you are a good stock picker and will get the direction right significantly more than half the time, then perhaps you can make money buying options.
However, there is much more to consider. See below.
Keep a written record of every buy/sell decision. This is part of your trade plan. Do not fudge the results because you would only be hurting yourself. If you have a proven (in writing) track record of being able to earn far more than your trading expenses, then buying options may work for you.
TIME. There is more to making money with options than getting the direction right. Because options have a limited lifetime, your predicted move must occur within the allotted time, and the sooner the better.
It is a bad idea to hold options through expiration because you will lose every penny that you paid for the time value in the option. It is far better to salvage some of the time premium and sell the option before expiration. The idea is to exit when you see the move that you anticipated. This is another reason why the expected price change must occur quickly.
SIZE OF THE PRICE CHANGE. You pay a premium when buying options and it is not enough to guarantee a profit when the stock price behaves. It must rally (or fall) by more than enough to overcome the time premium paid when buying the option. When you buy out-of-the-money options (as novice traders tend to do), the stock has even farther to move before profits can be earned.
OPTION PREMIUM. As you will understand far better when we talk about volatility, option prices often surprise the unsophisticated trader. When people are optimistic that the stock price will undergo a significant change soon (just before an anticipated news announcement, such as an earnings report), they pay a higher price for options (lots of buyers increases demand and increased demand leads to higher prices). The unwary trader may decide to buy call or put options when that anticipation is high, and therefore pay more than the option is worth. It is difficult to overpay for your options and turn the trade into a profit. Of all the pitfalls that an option buyer faces, this one provides the most disappointment. I received numerous questions from incredulous traders who bought calls one day, saw the stock rise nicely the next day, and discover that the calls lost value. This is (unfortunately) not a rare occurrence. When you learn more about "volatility" this will become clear.
There are many obstacles for the option buyer to overcome before he/she can earn a profit. The purpose of this post is to be sure that each reader is aware of those obstacles. If you want to make a bullish or bearish play, there are less risky strategies that come with an increased probability of success. The drawback is that profits are limited. As I hope to convince you later on, this is not much of a negative.