Stock Options are flexible investment contracts that serve several purposes. One of those purposes is hedging a large position–many hedge funds and institutional funds hedge their positions with options. However, another purpose that suits many smaller, individual investors/ traders is to use the leverage of options for a much smaller investment of capital. For instance, a trader with only several thousand dollars in his/her account may want to buy Google because he/ she believes it will go from say, $900 to $1,000 in the next 6 months. If this mythical trader only has $10,000 cash in their portfolio, then they can’t afford to buy more than 10 shares of Google and if they do, they won’t have any cash left for other trades that may come along.
The beauty of otpions are that they allow this same trader to invest a much smaller portion of his/her cash and still get the same kind of potential dollar gains as they would with an outright purchase of the stock. This leverage shows itself well with high beta stocks (ones that tend to move up and down in price quickly), because options tend to move up or down in
premium price on MOMENTUM. Thus, the price you pay for a call option can
change very quickly. Oftentimes, gain can come quickly and in large amounts! At other times, an OPTIONS TRADE can go under
water very quickly–if so, it’s likely you over paid on the PREMIUM (price) for the option.
drives premium prices to rapidly deflate, even if the underlying stock
price remains relatively stable? Two things that I can think of:
Time Factor. If you bought very short-expiry options, they can lose
price quickly even if the underlying stock price has moved only a
2) Momentum Factor. If the stock has a high beta (meaning
that historically the price tends to swing in wide margins from highs
to lows and back), then the premiums will change quickly and more
aggressively on any change in direction. I call this the momentum
factor, and high beta stocks tend to have the biggest momentum factors.
you want to avoid overpaying on premiums, there are a number of tricks
you can do but I don’t have enough time for all of them here. One simple
one is NOT TO BUY call options ON THE DAY THAT THE STOCK PRICE IS
SOARING HIGHER…rather, wait a day or two, and it’s quite likely the
price will pull back some and the PREMIUMS of the call options you want
to buy will often plummet! In fact, one trick I often use is to set a limit
order price that might be 20% or more less than the current premium with
an expiration about 2 or 3 days out, and I often will get the call
options I want by just letting the limit order fill a day or two later.
This is one trick of many.
usually doesn’t pay to buy call options (or puts) that are too far from
the current price….unless you have some extra money around and want to
speculate on a big move, but otherwise, it’s wise to stick to strikes
that are close to the money (or even in the money).
Another thing to consider is how far
to expiration? If you are playing with WEEKLY options, then these
animals can move very aggressively on price….I don’t fool with them
for that reason….I prefer options that are about 2 to 4 months from
expiry….if I guessed wrong on the initial move, then my call options
(or puts) won’t lose all of their value at once.
Yes, Weekly Options are highly volatile financial instruments….to me, it’s simply a form
of pure gambling! Weekly options are very short in time
existence, by nature. Anything that has a short life has a greater
chance of going wrong or not living up to expectations.
When I was young pony player (that’s a breed of gambler that has gone almost extinct in the internet age!), I recall that there were races at different distances….
were the typical 3 furlongs races (about 3/4 of a mile) and the 1+ mile
races….and there were the occasional quarter horse races. The quarter
horse races were very short races that lasted for only 1/4 of a mile.
Typically, anything could happen in the quarter horse races. You might
have placed a bet on the very best of breed quarter horse in the race,
but if that horse stumbled on the first step out of the gate, you would
likely lose the bet.
With 1+ mile race, if I put my money on the
best of breed horse, he could suffer a bad break or two like a stumble
at the start, and still have ENOUGH TIME to get back up to the top and
win the race.
So, in my humble opinion, if anyone is playing with
WEEKLY OPTIONS, keep in mind that even when you are betting on best of
breed stocks, that a weekly option is still like a lottery ticket. Sure,
it can win….but it’s just as likely to be a loser too. And with
Weekly Options, it’s often ALL or NONE. If the option fails to get in
the money very quickly, your ENTIRE INVESTMENT (or should I say “BET”?)
With Weekly Options, the trader is violating one of the
key rules to wealth accumulation, and that is to be sure you can get
most of your money back if the trade goes in the wrong direction.
Having the chance to get your money back allows you to place another
trade the next time without having to come up with more capital from
your next paycheck or your savings!
So, is the strategy of using options instead of stock a smart one? That depends, but keep in mind that unless you are a very good directional trader with well-honed instincts to know when the premium is fairly valued and when it’s not, using options instead of stock can get to be a very humiliating exercise. After all, the profits in options tend to be made by the people who “write” (sell) them….and most writers of options are big hedge funds and other well-heeled money behemoths who often own tens of thousands of shares in the underlying stock and then they sell options against those positions to create extra income for themselves.
Since these same “big money wheels” own large positions in the underlying stock, they have the ability to control bids and asks, and thus the price of the stock–which in turn, prevents the most popular options strikes from becoming profitable for those who buy them. By expiration, the big wheels pocket your premium and go about selling more options for the next round of “suckers.”
So, if one is using this strategy to substitute options for stocks, always keep this in the back of your mind that the entity that sold you the options is likely working hard to make sure you don’t make a profit on them. This being said, I will admit that I often use options myself in this respect because it allows me to hang on to more of my capital for other investment or trade ideas that may come along. However, I have years of experience in trading stock and options and in understanding a chart–these skills help me to score more winners with options than the average options trader. That being said, it’s still a tricky game for any trader, and I am still humbled now and again by certain options trades that went bad.