OPTIONS ARE YOUR
FRIENDS
I exchanged e-mails with a new trader who wanted
to discuss his trading strategy. He uses technical analysis to decide which
stocks to buy/sell -- and has been losing money. He asked about using options.
The following is a major part of my reply.
INVESTING VS. TRADING
Traders tend to ignore the nature of the business
and rely only on their ability to predict short-term price movements.
Investing is different. It is based on your
ability to understand the basic financial condition of the company, compare it
with its peers and make a good evaluation of how well-poised this company is
for the future. That's research. When you find a business that is worthy of
making an investment, you buy shares and wait for your good judgment to pay
off. But you do not wait idly. Investing requires periodic re-evaluation of
your holdings because the world changes and you do not want to be married to a
poor investment.
OPTION TRADERS
Option traders are not investors.
Nor are they very short-term traders. The option markets, with their
wide bid-ask spreads, are not designed for day traders.
·
Option
buyers require that the stock make a move -- in the right direction -- in
a relatively short period of time.
·
Option
sellers require time to pass and for the options to decay without the
stock moving in the wrong direction.
Option traders also have built-in risk-measuring tools (the Greeks) that make it more
efficient to use options than stock. The Greeks include Theta (the
risk of holding as time passes), Vega (the risk of holding a position as implied volatility changes) and
Delta (the risk of being too long as the market falls; or too short as the
market rallies).
These Greeks allow traders to get a good estimate of how much money
is at risk -- as well as the potential reward -- that comes with their market
prediction.
Why is this important? Too many traders ignore the following
question:
WHY DO I BELIEVE THAT I CAN CORRECTLY
PREDICT WHICH STOCKS ARE MOVING HIGHER OR LOWER?
Even when traders lack proof of any ability to correctly
predict direction, they still take bullish and bearish positions with a
high expectation of making money.
That is not reasonable.
Predicting direction is difficult. Most professional money managers cannot
consistently beat the market averages. And they are paid big bucks for that
inability. Instead of trying to do what they cannot do, why not trade with a
much improved chance of success? Options allow you to do just that.