Many of the individuals I speak with about options trading will typically tell me that they use them for one reason: speculating on a big stock move.
"Might as well risk a small amount of money", they say.
In other words, in case they're wrong, they don't have too much at stake.
I can get onboard with that if it's a one-time thing, and they feel like taking a gamble. It's no different than buying a lottery ticket. Hey, we all like to dream every once in awhile.
But when the activity becomes a long-term habit (which I see more often than not), then it becomes an issue.
Let me give you the reasons why I'm not a fan of buying options (speculating) on a big stock move.
Guessing A Stock's Price Is Hard!
When investors buy a stock, they typically have an idea of where the stock is headed - up.
Otherwise, they wouldn't buy it.
But when buying options contracts, you need to have more than just a general directional opinion. You need to have an exact price in mind.
Fine, you could do that. But can you really?
Seriously, you know what price the stock will move to?
On top of that, in order to win when buying options, you need the stock to move to your predicted price within the time allotted - the expiration date.
Unless you have a crystal ball (you don't), then predicting the where and when of a stock move is tough, tough, tough!
Here's an example:
Shares of Gap, Inc. (GPS) are currently trading near $19.54 per share.
Your thoughts are that it will rally again, at least getting back to its area of consolidation near $26 per share.
Instead of buying 100 shares at its current price of $19.54 and spending $1,954, your inner cheapskate tells you to buy a January 2020 $26 call option (hypothetical trade!) for a measly $.30 per contract.
Since each option contract represents a stake in 100 shares of the stock, that call option purchase will cost a grand total of $30 ($.30 x 100 share multiplier).
That's $1,924 less than buying the shares outright - a discount of 98.5%.
You think, "heck yeah I'll make that trade".
Here's why I'm not a fan: you won't see a profit on the trade until GPS trades above $26.30 ($26 strike price + $.30 option cost) if you hold it until the January expiration date.
Are you sure GPS can rally that much in six month's time?
Let's check the odds:
Based on the trusty probability calculator, GPS has less than a 10% chance of rallying that much by January. Said another way, there's over a 90% chance that it won't.
Those are horrible odds.
"But I'm only risking $30", you say. Yes, that's not much, but when you do it over and over and over again, the losses pile up. Eventually, you'll end up walking away from the game altogether.
What happens if GPS rallies to $25.90 by January expiration?
Well, since the stock price remained below $26, the option will expire worthless and the buyer will lose their $30 investment (100% loss).
On the other hand, shareholders will see a nice appreciation of $6.36 per share, offering a gain of $636. Options buyers got squat.
In a sense, length of the trade is another reason why it can cost you.
Most option buyers typically hold the trade all the way to expiration to squeeze as much time out of it as possible. But this action could cause them to miss taking potential early profits.
Did you know you could close out an option trade before expiration? Some investors don't, and that could be a big mistake.
Once again, what if GPS rallies to $25.90 next month but then falls back to $20 a few weeks later?
If you didn't pounce and lock in early profits, you'd give back those paper gains.
You might think: what's the point of closing out a trade early when there's months left before it expires? That's like paying for a full-day park pass but leaving after only one hour. You might miss out on hours of enjoyment.
Yes, that's true, and it's the thinking of most option buyers. But if you never take profits, you'll never be able to buy that park pass in the first place!
In my experience, in the end, the stock will rarely be able to move that far and hit the predicted level. Option buyers will walk away losing their bet.
Income Producing Is Better
As you know, I'm a big proponent of selling options, as opposed to buying them. Most of the articles I write focus on option-selling techniques which can produce current income.
When you're the seller of an option, you get the cash upfront from the option buyer. This gives you current income, much like a dividend check.
And by playing the odds, most likely the option will expire worthless, allowing you to win on a very large amount of the trades.
This is one of the most important reasons why I sell options: the sheer fact that I can take advantage of the odds - specifically the high odds of profiting.
Although I wouldn't be a seller of naked call options (unlimited risk), I do love the strategy of selling covered call options, as it's also a great income producing system.
In my Smart Option Seller service, we sell put options on high quality stocks that not only produce current income, but also allows for the opportunity to buy those stocks at really attractive prices.
Many investors don't know you can sell options, as they've only heard about buying them. It's a disservice to them, as option-selling is a great way to create ongoing cash flow.
But if you're still inclined to buy options, last week's post about Warren Buffet is the only option-buying technique I endorse.
Come join us and learn how to trade options profitably.
Until next time...