OPTION TRADER -- by Bill Kraft
Bill Kraft
Editor |
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Some Option Buying Principles
by Bill Kraft - Editor MarketFN.com Option Trader
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.
Good Trading!
Bill Kraft
MarketFN.com Option Trader
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