One of the most important concepts that newer option traders must understand is that options do not represent the path to instant riches. Options are investment tools that were designed to hedge, or reduce risk. In this author’s opinion, that is the intelligent way to use options.
Nevertheless, there are always going to be traders who love the idea of using leverage in an attempt to turn a small investment into a tidy pile of money.
There are two major difficulties with that mindset:
- The probability of finding success is small
- The trader/investor/speculator has to understand how options work before adopting any strategy—and speculators tend to dive right into the fray with no preparation
It is very tempting for a new options trader to believe:
- ‘All I have to do is wait until I am feeling especially bullish or bearish, then place a wager by buying a bunch of cheap calls or puts. Once the market moves my way, I’ll sell my options for a gigantic profit.’
- It is not that easy. In fact, it is a difficult prospect.
By not understanding how options work, the new speculator gets into trouble by:
- Buying options when the option prices are especially high. The more educated speculator understands implied volatility and buys options when the price is deemed reasonable, or fair-valued.
- Buying options with the wrong expiration date. Being bullish or bearish is not good enough. The options must remain alive (not expire) before the speculator expects this pending market move to occur.
- Buying options with the wrong strike price. This is a very common error for the inexperienced trader. It is tempting to buy the cheapest options, i.e., options that are far out of the money. Many times, the market move occurs, but the speculator’s options fail to produce the desired result. With even the slightest understanding of delta and gamma, the trader can buy options that offer a chance to provide a profit.
- Forgetting to sell the options. Another common speculator mistake is holding onto his options until expiration arrives. Being familiar with the concept of time decay and understanding that options are a wasting asset can save a trader a lot of money. When buying options, the idea is to sell as quickly as possible—once the hoped-for market move has occurred.
I do not recommend using options for speculation. However, if you insist on using them that way, then at least give yourself a fighting chance. Take the time to understand the basic concepts of options. Learn first, trade later.
Mark D Wolfinger
Options for Rookies