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.