- Option trading has been considered by many to be speculative and dangerous, and the buying of stock, in comparison, to be conservative and safe.
Despite these views, the crushing bear market of 2008 saw the Dow and Nasdaq dive in value, with many “safe stocks” dropping 90% in value.Truly, buying and holding stocks in 2009 could be a disaster… and many investors will turn away from the stock market, period. It’s becoming a
short-term trading market, and those investors who understand that… and can act on it… will have a chance to prosper this year.That’s where trading options for profits can be important for you to consider.
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Option Trading Volume Has Exploded
Option trading volume exploded in 2008 when nearly 3.6 billion option contracts were sold for a 24% increase in volume — a record number of options
traded in one year!The options market is the best medium for the individual investor — giving them an advantage. The small investor has a weapon to compete with the
big institutions on Wall Street. You can take your turn being the house, rather than being a pawn to be pushed and shoved by the big boys.
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The Secret Advantage of Trading Options
If you would have owned options in 2008, you could have greatly limited your losses. The big advantage of options is that you have outstanding leverage,
but (and here is the key) with
limited risk. You can only lose what you pay for the options, and that can be a small amount.Therefore, instead of owning highly risky financial or banking stocks that have a dramatic amount of downside risk, you could receive the same kind
of leverage by buying options and utilizing option strategies while only risking 10% of your portfolio.The advantage of option trading does not stop there. Options enable you to buy an insurance policy on your stock portfolio that is not available
from any insurance company.With options you can design investment strategies that will profit regardless of what the market does. Besides, you can design these strategies
with extremely attractive risk-reward pictures, much better than any other investments.Options are an extremely valuable risk-reduction, profit-maximizing tool. In fact, for all investors, options are an extremely valuable tool and
can be used with all of your investment activities.But, like all miracle drugs, options must be used with prudence and proper care, for if you overdose, options can be dangerous to your financial
health.
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Trading Puts
Options are actually quite easy to understand. You already know how puts work, since you own car insurance, which is essentially a put.
The insurance policy protects you against the loss of your vehicle, and the inputs that go into pricing the put are virtually the same as those
that go into pricing your car insurance. Let’s take a look and do a quick comparison:1. The car is like the stock. You’ve got a lot of cabbage invested in both and you’d like to protect it should either get into an accident!
2. How long you elect to protect the asset is the term, or in options parlance it’s known as the expiration.
3. The deductible describes how much loss you are willing to take before the insurance kicks in. If you want zero-deductible insurance, you will
pay more than if you want $500- or $1,000-deductible insurance. The same is true for puts, as the at-the-money put is a zero deductible and a $5 out-the-money
put kicks in after your stock has fallen by $5.4. The premium is how much you are paying for the protection!
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Buying Calls
Calls work the same as puts, except they give the owner the right to buy, not sell the asset. Donald Trump routinely uses options on real estate
to speculate and accumulate properties.He doesn’t buy one single building, he buys an option to purchase at an agreed upon price. When he’s got the block under control, he
exercises his right to buy and builds his newest tower! Calls on real estate and calls on stocks are virtually identical.1. The building is like the stock.
2. How long you elect to have the option to purchase the building or stock is the term.
3. The premium is how much you are paying to the building owner or market makers in the option for the right to buy at a set price!Seems simple enough doesn’t it? Actually, it is quite simple, but option buyers frequently complain that they don’t seem to win (make
money) as often as they should. This may indeed be true, but the reason isn’t because the pros have conspired against them; it’s because they
stacked the odds against themselves!
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Why Do You Think Vegas Casinos Are So Lavish?
I visit Las Vegas regularly, and it never ceases to amaze me how big, extravagant and crazy that city is! As I walked from the Bellagio across to
Caesar’s Palace, I glanced at my watch. I walked through the lobby, sports book, casino and then through their over-the-top shopping center.
Without stopping to gamble or shop and walking at a brisk pace it took me 35 minutes to walk from the entrance, to the end and back!From the moving statues, to fountains that put Rome to shame, to curved escalators rising four stories into space the experience is jaw-dropping.
And I’ll bet (no pun intended) that the majority of people who take in Caesar’s Palace, or Bellagio, or the Venetian, or Mandalay Bay,
or any of the dozens of spectacular casinos that dot the strip will come away with a similar thought: they don’t build these modern-day palaces
because the house loses!uently complain that they don’t seem to win (make money) as often as they should. This may indeed be true, but the reason isn’t because
the pros have conspired against them; it’s because they stacked the odds against themselves!
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At Least Casinos Buy You Drinks As You Lose!
The same principals that pay for those five-story atriums, volcanoes and fighting pirate ships for the casinos are at work against option buyers;
the chumps bet against the odds!In the options business that means buyers violate two primary principals:
1. They don’t give themselves enough time to be right, and
2. They mistake cheap options for inexpensive options.
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You Need Enough Time to Be Right
Options are a wasting asset. They are not perpetual investment instruments. The closer you get to expiration, the faster the option decays. If you
think about why that is, you’ll understand the concept without going back to your college calculus book.Picture two options contracts, both at the same strike price but at different expirations. So we’re looking at Option A that expires on March
20 and the other (Option B) that expires 28 days later on the third Friday in April.At the beginning of March, Option A will have 20 days left until it expires and Option B will have 48 days left until it expires.
In those 20 days, Option A will either turn into stock or it will disappear. By that I mean that the price of the stock will rise and we will exercise
our call to obtain shares of stock, or we will let the option expire without exercising it.Time decay is so intense in these options market makers will hiss, imitating the sound of air escaping a balloon! Meanwhile, Option B has 48 more
sunrises and sunsets for the stock to move in their favor, so the odds significantly favor the investor that bought the option with more time.Option buyers who find they are frequent losers rather than winners are buyers of near-term options that have stacked the odds against themselves
buy buying the option with so little time for them to be right. In most all situations I want to have another month or more to be right, but in extremely
heavy buying situations, I may dabble in front month options, but I do so very carefully.
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There’s Cheap and There’s Inexpensive
The other mistake option buyers make is they think an option’s price is an indication of whether it’s cheap or expensive. Rather than
buying the at-the-money $25 call that is selling for $1.75, they buy the $30 call that is selling for 50 cents. They could buy three of those $30
calls for the price of just one $25 call! All too true, but there’s a reason for that apparent cheapness.You see the mathematical models that have been created to price options are very similar to actuarial tables that insurance companies use to figure
the risk they take on writing policies on life, health and automobiles. But you don’t need to understand how the tables work, you just need
to know there are sophisticated computer programs that have already done the work for us, and neither professional traders nor casual investors need
be overly concerned about how or why such formulas work.Read Ken Trester’s “Cheap Options Aren’t Always
a Smart Buy”The models predict the future price of the stock based on historical trading patterns much like the insurance company’s models project the
longevity of a particular demographic. Thus, buying that out-the-money $30 call that looks cheap, but what you are really doing is betting the stock
will trade outside the expected range of projected prices. Don’t get me wrong, sometimes the outcomes are indeed outside the range predicted
by the models, but you should understand you are betting against the odds!
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Don’t Bet Against the Odds, Bet with Them!
To put this in gambling terms, when we invest properly with options we are betting with the odds in our favor and when we invest in the cheap options
we are betting against the house! In roulette the probability of hitting the single number is 1-in-38, or 37-to-1. Therefore, if you bet a $1 chip
on this number 38 times you will win only once. The payoff for this bet is 35:1. So, the dealer will give you $35 and you also keep the dollar you
bet. In total, after 38 spins you will lose two dollars that is 5.26% of 38 wagered dollars. So, the house edge on the single bet is 5.26%.Suffice it to say that the house edge (market maker’s) in options is substantially better than that 5.26%! When you invest in the wrong options,
you’ve really moved the odds against yourself. You’d be better off playing roulette in a casino, because they buy the losers drinks!Since we all want to be long-term winners, you’ve got to invest with the odds in your favor. As I’ve shown, that doesn’t mean
you need to be a math wiz, or computer genius to invest with the best chance of winning. You just need to avoid the chump bets!More from our analysts:
