I’ve gone round and round for years on whether I ever wanted to write this article. Nothing has destroyed more portfolios than trading options, so let me start off by saying probably the best decision you could ever make is to avoid them.
That being said I understand how human nature works, and if I tell you to avoid them it will just make most people want to experiment with them even more. Let’s face it the lure of quick, easy, and big money is just too tempting. And trust me your broker will love you if you start trading options. The fees they garner from options are massive compared to regular brokerage fees. Options writers will love you because most of the time they will make money off you buying what they are selling.
Trading options is like gambling, most of the time the casino wins.
However, there are a few things you can do to swing the odds a little bit more in your favor and hopefully prevent you from destroying your portfolio.
The single biggest mistake almost all option buyers make is they don’t buy enough time. Most of the time markets are consolidating. Options decay during periods of consolidation. Let’s face it if you are buying options then you are almost certainly overconfident in your ability to predict the near future in the market. You think price is about to move up or move down strongly. The problem is that if you buy front month, or near month contracts and it takes longer than you expected for the move to progress you end up losing on your trade, and with options that means a total loss if price doesn’t move beyond your strike price before expiration.
So here is a common mistake many options traders make. They expect the market to rally, or drop, so they buy a front month contract a couple of strikes out of the money and then sit back expecting to get rich within a couple of weeks. Then invariably what happens is the market waffles around for a week or two and time decay quickly shaves off 50% of your options value. Most traders when they lose 50% in a position panic and sell to prevent it from becoming a 100% loss. So it’s possible you had the correct trade, but you just didn’t give it enough time to work.
In this sense it is critical that you understand cycle theory. You have to know when the current intermediate cycle is expected to top or bottom and purchase any options with plenty of time to get you past that potential top or bottom. Folks, if you are trading options without a clear understanding of cycles analysis it’s like running through a dynamite factory with your hair on fire. Yes you might survive, but you’re still an idiot.
To correct this mistake you absolutely have to enter the trade expecting that you are going to be completely wrong on the timing of the move, and so consequently you need to buy way more time than you originally anticipate. I suggest that whatever time you expect a move to unfold, you buy at least 3 times that amount of time as a margin of safety. So if you expect a move to take 2 months, you should buy at least 6 months of time to protect against the tendency to overestimate your ability to predict the correct timing. You should go into every options trade with the confidence that you have the direction right, but that you have the timing wrong.
The next thing you need to understand is that the concept of using stops on options trades is an almost sure fire way to destroy your portfolio. Folks options are so volatile that any little wiggle in the wrong direction can shave off 20-50% of your option value. For most people that triggers panic and they sell. The fact is that options are driven by the underlying asset and stops should only be applied to that vehicle, not the option. So as long as the underlying asset hasn’t done anything wrong there is no reason to stop out of your option position. The problem is that by the time the underlying has signaled that you have the wrong direction your option will be pretty much worthless.
So when you take a directional option trade understand this is for all practical purposes an all or nothing bet. So for heavens sake don’t bet more than you are willing to lose, because if you get direction wrong, or don’t buy enough time, then you are going to lose 100% on the trade.
Now let me show you an example of what a typical options trade might look like. Let’s use the current biotech trade as an example. Let’s say like me you witnessed the stock market bottom in February and it wasn’t long before biotech began to confirm a bottom as well. Based on how extreme the stretch was below the 200 day moving average you anticipate a pretty strong rally is impending so you start buying call options to profit from that rally. What you don’t anticipate is that the bottoming process might take longer than you expect. So instead of IBB immediately following the market higher it churns around in a basing pattern for 2 months. If you didn’t buy enough time your options have experienced serious decay and probably can’t recover. This is a classic example of overestimating your ability to time the beginning of a move.
Now let’s look at the other bugaboo that could potentially wreck this trade. Assuming you bought at one of those points I noted in the above chart once IBB started to show promise of bottoming what you didn’t count on is the back and forth. Let’s face it you were sure that price was going to follow the stock market and rocket higher producing riches by now. Instead what it did was churn back and forth. So instead of getting rich what has happened is that you’ve watched your options lose half their value or more at least twice now since you bought them. Most novice options traders would have stopped out by now and taken a massive loss on the trade, but the underlying asset hasn’t actually done anything wrong so there really is no reason to stop out of the trade. So far your call on direction is still correct. The only thing you missed is timing.
So let me stress again that if you are going to trade options you almost have to treat them like an all-in bet at the poker table. You have to trust that you have a winning hand to make the bet, but know that if you are wrong you aren’t going to be able to pull your chips back off the table. Directional options trades are all or nothing bets. Have the courage to trust that you have the direction correct and the balls to let the trade work even if you missed the timing. But also understand that the consequences of being wrong on direction will result in a complete loss. So only bet what you are willing to lose.
And a last word: one way to protect somewhat against a complete loss is to not only buy more than enough time, but also use deep-in-the-money options. It will dramatically improve the odds of price staying above or below your strike even if you get everything else wrong. And that way at least you won’t lose everything.
Like our new Facebook page to stay current on all things Smart Money Tracker
Thank you for posting these thoughts…although intuitive, they are insightful and as always you know how to get your point across through your writing.
Good advice. I’ve lost enough money on these lottery tickets to know they are nothing more than gambles.
Naked options are the way to go to make time decay work in your favor.
Good advise. I also learned it hard way.
Any example what would u buy in ibb options now?
Of course, as you alluded to, one can always write (sell] options to open. I especially like selling put options on position I want to eventually own, but at a lower price.
If I get my shares, I typically get them near the bottom of their range, and if not the options expire worthless and I keep the premium from the sale.
Also, on thing you didn’t mention that is key when buying options, is to always manage risk through size. You can but an INTC Jan 2018 25.00 call for appx 8 bucks. INTC is at almost 33 right now, so you’you’re getting lots of time and spending almost nothing extra to buy it, w a risk of 800.00 for one contract [controlling 100 shs). If an 800 loss won’t kill your portfolio, this is a way to control more stock with less capital, and by limiting the number of contracts to control risk, allows options to be used sensibly.
I agree w you though, Gary. Mist people get around options and lose their sense of risk, and this is a vehicle that requires extra risk management and savvy.
one could buy a debit spread or as Gary says a leap option deep in the money with a high delta. both of these will use less capital than buying the stock outright
out of the money options are cheap and really risky. as Gary says give yourself plenty of time and bet small….
one other thing to note that buying options at present makes sense as volatility is very low. Even if biotech or the s&p goes nowhere for a few weeks , you will still make money with the right options trade if volatility expands from here
Options are worse than gambling IMO because it deals with the market and with TA you think you have more control… but the truth is there’s no room for error. The problem is that option is losing value as soon as you buy it and so you can be right and still be wrong.
In regards to the markets, I feel as though IBB is just at the top of its range (been a great trade) and now has to proof itself and the Spx as well. I would not be surprised to see significant pullback here across the board… or a consolidation before new highs.
Options scare me. Am I less of a man for saying so?
I looked into them a few years back and I don’t mind admitting I did not fully understand them – and I am a pretty smart guy, so I am told. I just got the impression that the House is always most likely to win.
IBB : cancer immunology
The weekly charts all look good. Certainly nothing portending an eminent top.
The IBB optix over at Sentimentrader just hit 91, the highest reading in 5 months & well into excessive optimism territory. If it can shake this off and continue higher then I’ll take a flyer on a couple hundred shares.
I do not know enough about them. I look at my account and I have the right to trade them. However, it looks like I have to exercise them. In a trade for a stock I think will go down in value I have to exercise the option and sell the shares. If I am right then I buy the shares back at a lower price which I can then sell, pocketing the difference. With an option I believe will rise in price I have to hold off until it rises in price then exercise the option and sell the shares at a profit. What I cannot do, by the looks of things is simply buy or sell the options until they become more valuable. Is there a difference between Europe and USA in this?
You don’t have to exercise an option. Most traders don’t. You can buy or sell at any time.
The one difference in European options is that you can only exercise Europeans at expiration, US options can be exercised at any time. That is one of the risks in selling options here in the US. It could get exercised at any time.
Thanks for the info. On my trade site at Saxo Bank, the wording makes it look like I have to exercise them. I have access To US options and the word usage is the same. It has always put me off trying them. Perhaps if options are what you use in the Quest, I should wait until the next opening there and give that a go. I am certain I do not know enough about options to go it alone. The training videos I have seen are not useful at Saxo.
Thanks for the info. On my trade site at Saxo Bank, the wording makes it look like I have to exercise them. I have access To US options and the word usage is the same. It has always put me off trying them. Perhaps if options are what you use in the Quest, I should wait until the next opening there and give that a go. I am certain I do not know enough about options to go it alone. The training videos I have seen are not useful at Saxo.
So, if I bought US call options I do not have to wait until expiry even if they are bought from a European account?
There seems to me to be a lot of insularity regarding Europe and USA in this. A few years ago when buying American stocks I actually got phone calls from Saxo asking me what I was doing! But I have no interest in trading European markets. Never have.
Most Index options such as SPX are European style options, which offer not only the exercise date at closing only and are taxed at 60% long term. They are the only options I trade. Credit Call spreads on SPX way out of the money.
Thanks for the tutorial on the risks and costs of stock options, Gary….since my approach to investing is fundamentally conservative, stock options are too risky for my tastes….
I remember a few years back you saying that options destroy all portfolios , no exceptions
Close, but not exactly what I said.
I said heavy leverage will always eventually destroy one’s portfolio. You can trade options without using heavy leverage. For instance you could only use 1 or 2% of your portfolio for any options trade.
Good advice Gary. I had some SLV 14.5 put options that expired March 31. If I had only bought one month (one more day!) more time I would have made lots of money. Instead I had to sell before they expired and lost 80 or 90 %. I made some big money on my AG 2017 call options so I am well ahead at this point but losing money always sucks!
Gary is a smart man … why Fast Money on CNBC not hire him? 🙂
This should tone down the freakout factor witnessed around these parts ?
Also for me a testimonial:
2009: 1st year trading options
Made a fortune
Use ONLY what you can afford to lose
10% of my portfolio
2010 to present: Never dabbled again
ETF investing is my only source here on out whether leveraged or not adjust accordingly with risk and time management
biotech has not “confirmed” a bottom at all, unless youre talking a very short term. Whether it does or not remains to be seen but confirmed yet it has not, other than your opinion.
I do trade options Gary and have done quite well with them I always buy three months out ITM and usually up or not I sell 30 days prior to expiration I’ve done well with that strategy.
Or sell options. Calls or puts but Covered calls are clearly the safest. 80% of calls expire worthless. I have made money on GDX 8 out of the last 9 weeks including this week. Will work great in a sideways market. Not as well in a down market.
Options aren’t scary. Lack of understanding is the fear-driver. If anything, stay away from leveraged ETFs.
Best strategy with options is to buy in or at the money and go 3-4-6 months out. Deep in the money high Delta isn’t necessary and can generate a higher loss as the contracts move more percentage-wise with underlying move. Of course, they also move up faster. It is best to achieve a balance, say a Delta of 0.50 to 0.60 range.
Realistically, very few people plan to hold the options to expiry. Even fewer exercise them, mostly happens with covered call situations.
I would pick options any day over leveraged ETFs. I know how options work, no one here can understand what the prospectus of DUST JNUG NUGT and all those widowmakers even mean.
Gary is right, options are dangerous. I have blown up account before trading them. They are powerful when used properly but I would say one should trade options with only about 10% max of portfolio. The best way to options that no one talks about is selling them not buying them. You won’t make as much but it’s a higher probability of winning than buying. I will try to open a new account dedicated to this. Selling puts specifically on stocks that I don’t mind owning