Two Predictions

When I first started trading someone told me that the stock market was like the world’s largest casino.   And let’s be honest, we like the prospect of a good quick return once in a while.  That’s why we trade options. 

If you own a stock, and the price goes down, you can continue to hold on to the stock and wait until the price goes back up.  That could take days, weeks, months or years.  With options, you don’t have that luxury.  Options expire.  On day the option expires you need to be “right” on two predictions:

• Direction of movement of the underlying security

• A time before which the movement occurs

Sometimes you get one out of the two predictions correct.  That is not good enough.  You have to be right on both predictions.

As an option trader, you have to be prepared to lose whatever you paid for the option. There will be no government bailout money in the event you get it wrong.  With leverage comes risk and the possibility of a total loss of your option investment. 

 Trade Note from Peter

I find it interesting that most investors easily qualify to trade long calls even though the strategy is one of the riskiest of all option strategies and often the fastest way for investors to lose their money.  At the same time, it is one of the easiest option strategies to understand, so I guess it makes sense that people trade a lot of them. 

Why are they risky?  In my view, traders blow themselves up not so much because they don’t understand the ins and outs of trading options but because they are constantly swinging for the fences.  In a sense, they don’t understand themselves as speculators.  As a long call investor, you should take personal stock in how you manage risk.  In addition, you should consider whether research and technical analysis can reduce risk and improve the odds of predicting short-term movement of a stock.

Trading Tip: You should always make sure that there is enough liquidity in market relating to the option you want to trade.  Look at the level of interest and the trading volume of the option you want to trade.  There is nothing worse than a thinly traded option that you can’t sell or fill at a good price.