In options, not understanding risk can empty your bank account faster than a 400-pound man emptying a buffet. Risk is everywhere on Wall Street, but you needn’t simply accept it. Instead, you can conquer it with stock options.
Contrary to popular opinion, option trading is actually quite easy. In fact, I can prove that you already know how put options to work. How? Well, because you likely have car insurance, which is essentially the same thing as owning a put option. You see, the insurance policy protects you against 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.
Look at it this way; the car is like a stock. You’ve got a lot invested in both, and you’d like to protect them should either get into an accident. How long you elect to protect the asset is the term – or, in options parlance, the expiration month. 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 a $500 or $1,000 deductible.
The same is true for puts, as the at-the-money put (i.e., if the strike price equals the current market price of the underlying security) is a zero deductible and a $5 out-of-the-money put (whose strike price is below the current market price of the underlying asset) kicks in after your stock has fallen by $5. The premium is, of course, how much you are paying for the protection.
‘Call’-ing The Odds Into Your Favor
Calls options 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; rather, he buys an option to purchase several buildings in the area at an agreed-upon price. And then, when he’s got the block under control, he exercises his right to buy and then he builds his newest tower.
The building here is like a stock. How long you elect to have the option to purchase the building or stock is the term. 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.
Option buyers frequently complain that they don’t seem to win (i.e., 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’ve stacked the odds against themselves!
You Need Enough Time To Be Right
In the options business, option buyers generally tend to violate two primary principles:
1) They don’t give themselves enough time to be right, and
2) They mistake cheap options for inexpensive options.
I like to describe options as a wasting asset. They are not perpetual investment instruments. The closer you get to expiration, the faster the option price decays. For example, let’s take two hypothetical call options, both at the same strike price, but with different expiration dates. Let’s assume Option A expires on the third Friday in January (remember, options expire on the third Friday of the month); while Option B expires two months later on the third Friday in March.
Using 2008 as our example, Option A expires on Jan. 20 (again, remember, options expire on the third Friday of the month); Option B expires on March 17. Now let’s suppose it’s the first trading day of the year, Jan. 4, 2008. That means Option A has 16 days left until it expires and Option B has 57 days left until it expires. (Remember, 2008 was a leap year, so February had 29 days.)
In 16 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 at the strike price, or we will let the option expire without exercising it. Time decay is intense in these options because of the truncated time frame.
Meanwhile, Option B has 57 more sunrises and sunsets for the underlying stock to move in its favor, so the odds significantly favor the investor who bought the option with more time. Option buyers who find they are frequent losers rather than winners are often buyers of near-term options who have stacked the odds against themselves by buying an option with so little time for them to be right. In most situations, I recommend having 30 days or more to be right.
When you invest in the wrong options, you’ve really moved the odds against yourself. In fact, you’d be better off playing roulette in a casino, because at least the casino will buy the loser a drink!
There’s Cheap and Then There’s Expensive
Giving yourself time to be right starts with looking beyond an option’s price to find the real value, because investing in the wrong options really means moving the odds against yourself.
Rather than buying an at-the-money $25 call (which means that the strike price of the option equals the market price of the underlying security) that is selling for $1.75, a novice might buy the out-of-the-money $30 call (i.e., the strike price of the call is higher than the price of the underlying asset) that is selling for 50 cents.
Sure, they could buy three of those $30 calls for the price of just one $25 call, but there’s a reason for that apparent “cheapness” – it’s a long shot. The out-of-the-money $30 call looks cheap, but buying it means betting that the stock will trade outside an expected range of projected prices.
Don’t get me wrong – sometimes the outcomes are indeed outside the range predicted by price models that determine where a stock will be trading in the future, but you should understand that you are betting against the odds. Sometimes you’ve got to avoid that “cheap” bet at all costs!
If you want to trade like the pros, don’t invest against the odds – invest with the odds in your favor. Option buyers who find they are frequent losers rather than winners are often buyers of near-term options – they stack the odds against themselves by buying an option that gives them too little time for them to be right about the stock’s performance by expiration Friday.
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. There’s no need to be a math whiz or computer genius to invest with the best chance of winning – you just need to avoid those sucker bets!
Ken Trester started trading options when the first exchanges opened in 1973. He has been a computer science professor at Golden West College in Huntington Beach, CA, where he also taught a course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron’s.