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March 30, 2012 at 8:41 am | | Comments 3

Why Your Option Trades Fail

Frequently traders will tell me instead of trading the common, that they’re eyeing the options instead.  The idea is that they can ‘control the stock’ at a much lower price, which is correct, but it’s not as simple as they expect.

For example, with XYZ trading at $50, the $55 call might look cheap by comparison at $0.25, and many will go this route of buying a ‘cheap’ call instead of the shares.  That isn’t much, but with only about a 10% chance of finishing in the money by expiration, the odds certainly aren’t favorable.  Then consider the fact that to turn a profit, the stock has to move even higher ($55 + $0.25 paid for the call), and the likelihood of turning a profit diminishes even further.

Whether it’s options or common you’re trading, you never want to be in a position where you NEED the stock to make a sizeable move to just get your money back.

So the next time you’re considering buying an option instead of the stock, go deep in the money and consider paying what might look to be a more expensive price.  The odds are more favorable, and you’re not putting yourself in such a needy position from the outset of the trade.

Trade Like a Bandit!

Jeff White
Producer of The Bandit Broadcast

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  • http://blog.mdwoptions.com/ MarkWolfinger

    Jeff,

    You are correct in that buying options is generally a foolish game. And you are even more correct when you say that too many traders would by the out of the money call (55s in this example) because it is cheap.

    However, the stock does not have to move beyond $55.25 for the option buyer to earn a profit. All that is needed is for the option price to increase – as it will if the stock moves higher – quickly. Quickly is the key.

    I believe this would be a foolish purchase and agree that owning the 45 call is a much better choice. However, it is important that the option buyer understands that holding all the way through expiration day is a losing strategy. When you buy an option, the idea is to sell quickly (after the stock has made its move), and not to watch the time value erode.

    Regards

  • Anonymous

    Hey Mark!

    Excellent distinctions and I appreciate you pointing them out. Secretly, I had hoped either you or Adam Warner might chime in as you are the option experts, so I’m glad you stopped by!

    I debated whether or not to publish this post as I don’t want to get in over my head discussing options (being an equities guy), but I just see so many people making this mistake I had to point it out.

    Hope you are well and thank you again for adding your thoughts Mark!

  • http://blog.mdwoptions.com/ MarkWolfinger

    It was good to publish because you made the major points.