Have you ever felt like you’re banging your head against a wall, trying and trying to make good profits on a good-sounding options strategy? Most experienced options traders have definitely had that feeling from time to time – in fact, the most frustrating moments can be the ones where you’re ready to learn something new and break out of a trading rut.
Take this forum comment by TK client TampaJake. He writes: “The options game has separated me from more of my money than I wish to discuss, so I stopped the madness….Options rarely rebound with the time decay factor. In fact sometimes the stock price goes up and the call price goes down if you are not savvy to pick the correct option. Just too many factors to consider: price, open interest, expiration, delta, past history of the underlying stock, etc.”
TJ: options are definitely not for everyone, and it may be perfectly reasonable for you to be among those for whom this versatile investment tool is unsuitable. That said, I felt compelled to probe further when I read your reasons for swearing off options.
Judging from your complaints, I conclude that your exposure to options has been as a buyer. If so, I’m not surprised you’ve had a tough time turning a profit this way. Buying options successfully takes considerably more skill and luck than buying stock. With option buys, you must be right on direction, timing, and size of move. Not only that, but you must not overpay when buying.
Here’s a concrete example of how difficult options buying is: in TradeKing’s Intelligence Report Top 10 Mistakes New Options Traders Make (PDF), guess which mistake ranks #1? You got it: “Are you starting out by just buying call options?”
The tough odds on buying options makes me wonder if you’ve considered taking the other side? Why not have the odds of success stacked a bit more in your favor, and at the same time, adopt methods that limit your loss exposure?
Cheap options: cheap for a reason
From a quick peek at your trading history, it seems you trade stocks in odd lots, or amounts that aren’t in round-lot increments of 100 shares. Nothing wrong with that; however, you can easily get in over your head with options trades based on odd lots. It’s very important not to get so excited about an option strategy that you take on too much risk.
Let’s assume you have a bullish feel for a stock priced at $25. Instead of spending $1,000 to buy 40 shares (for example), in the past perhaps you may have considered buying a few call options with a strike price of 30. These out-of-the-money call options are usually cheap, so it can be tempting to buy a lot of them. The potential payoff is large, but it’s very unlikely to be achieved. If that was the trading strategy you employed, it’s no wonder you lost money in the option markets. (For more on this, check out Brian Overby’s post cheap options = lottery tickets.)
Up your odds of success with put spreads
Instead, it might make more sense to establish a bullish position with limited losses, and of course, limited profit potential - but with a much higher chance of success than your old strategy of buying call options.
For example, suppose you sold 2-lots of the Aug 22.5 puts and bought 2-lots of the Aug 20 puts. This is referred to as selling the August 20/22.5 put spread. The maximum loss is $250 per spread: minus the premium you collected from the leg sold, plus the premium spent on the leg bought. And if this stock does indeed NOT decline past 22.5, per your prediction, you get to keep the premium, and earn a decent return on your investment. The stock doesn’t even have to move higher for you to earn the maximum profit. (For a two contract spread, don’t forget to include total commission costs of $25.00 to enter and exit this trade: $4.95 per leg plus 65 cents per contract traded).
But be careful. Do not sell too many of these put spreads. That’s the real risk: too much size. Why? Despite your prediction, this stock can indeed decline well below 20.
If you can sell that spread and collect $30 for each, you must decide if that potential reward ($30) is worth the risk ($220 maximum loss). But, so long as you understand and plan for these risks, you’ve also upped your chances of winning on this trade. Mainly you need the stock to not drop by too much. You could win on a rally, you could win on no change, and you even win down more than $2 per share. No need to bet that it moves near enough to 30 so you can sell your calls at a nice profit. See how, this time, the odds will be more on your side?
A few other risks to keep in mind: multiple-leg options strategies, like put spreads, involve additional risks and multiple commissions and may result in complex tax treatments. Consult with your tax advisor as to how taxes may affect the outcome of these strategies. You may also find it helpful to review this strategy in detail – just login to your TradeKing account, then go to Education > The Options Playbook, Play #16 (Short Put Spread).
I should also mention that the above example is an imaginary projected return, simplified by disregarding account expenses like taxes; in the real world, you should factor this into your calculations. This example also assumes none of the options mentioned get exercised or assigned before expiration – but in the real world, that can happen, so please plan accordingly.
Obviously, you know yourself and your risk tolerance best – so if you decide options aren’t right for you, stick with that choice by all means. But if there’s even a part of your brain interested in learning more about options, remember there’s no need to rush into trading options without learning more. Visit http://blog.mdwoptions.com/ for more tips and insights like these.
Regards,
Mark Wolfinger
Founder, MDW Options
TradeKing All-Star Commentator
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
Supporting documentation for any claims made in this post will be supplied upon request. Send a private message to All-Stars using the link below the profile image.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Mark Wolfinger maintains a cross-marketing relationship with TradeKing.
