With the market going up, there will be an increasingly larger number of people buying call options on those stocks they expect to go up even further. However, there will also be an increasingly larger number of people losing money on those very same call options designed to make money as the market rises.
There’s nothing worse than buying an option (call or put), and seeing the market ultimately move in the direction you expected, but still losing money on your option nonetheless.
This is usually the result of some all too often made mistakes.
The good news is that these mistakes can easily be corrected.
I’ll outline three key mistakes that options traders make, and then provide a solution for each one them.
Problem #1) Unrealistic Expectations and Low Probability Options
I was going to name this first point ‘greed’. But it’s really just human nature.
Too many investors, after identifying an opportunity, are tempted to swing for the fences and load up on a position.
They’ll go out and buy a bunch of cheap options (so they can buy more of them), but with deltas so pitifully low that they’d need to see a gigantic move for those to ever payoff.
Solution: Focus in on the options with a delta of at least 60%, and preferably 70% or higher.
The delta tells you how much your option should move in relation to the underlying stock.
But the delta is also considered to be a gauge as to what percentage likelihood there is of the stock reaching that option’s strike price by expiration.
An option with a delta of 75% means there’s a high likelihood (a 75% likelihood) that that option will expire in-the-money.
A delta of 20% means there’s only a 20% likelihood of that option finishing in-the-money. And do you really want to load up on a bet with only a 20% chance of success? I don’t.
Problem #2) Not Buying Enough Time
Whether you’re expecting a stock to go up or down, we have a tendency to overestimate the size of the move that could be seen, and underestimate the amount of time it could take to do it.
With an option, if you run out of time, it’s game over. And with many investors skimping on how much time they buy in their options, this happens all too often.
Solution: However much time you think it’ll take for your stock to do whatever you think it’s going to do, add at least one more month to it and buy the option with at least that much more time.
Plus, the options with more time are almost always the better value. An option selling for $500 with 2 months of time may seem cheaper than a $700 option with 4 months of time, but it’s not the better value.
For example: $500 divided by 2 months means you’re paying $250 for each month of time that you purchased.
But $700 divided by 4 months means you’re paying only $175 for each month of time. That is the better bargain. And more often than not, you’ll be glad you had that extra time as that can make the difference between making money on your trade or losing it all.