WHY YOU SHOULD AVOID TRADING OPTIONS

ALL TOGETHER

Option trading is complicated and you should probably stay away.

I’m not kidding.

Did you know the guys who created the stock option pricing formula (known as the Black-Scholes-Merton model) started a hedge fund (Long Term Capital Management) and lost so much money that they had to get bailed out by the Federal Reserve Bank?

True Story…

Ironically, they received the Noble Prize in economics less than a year from their epic blow up.

Now, at this point, if the guys, who wrote the playbook on option trading couldn’t get it right, how do you stand a chance? After all, trading options requires you to have an opinion on stock price movement and volatility. And oh yeah, your timing has to be spot on.

Good Luck!

At this point in time you’re probably saying to yourself: “Hey Josh, don’t you own OptionSIZZLE, a website dedicated to helping investors achieve greater success through the use of options… and aren’t you destroying your business by telling us this?”

My answer in one word:

“No.”

I’ll explain my reasons a little later on. But first, raise your hand if this has ever happened to you or someone you know:

Have you ever bought a call option on a stock, believing you’ll see the shares of the stock price move sharply higher…get the expected move, but still end up losing money on the options?

Heck, I’d be lying if I told you it’s never happened to me before. And frankly, it can be instantly traumatizing….enough to swear off options forever.  

Why do you think most investors stick to just buying stocks?

First, they’re easy to understand. For every dollar the stock price moves higher…you make a buck on each share you own.

On the flip side, for every dollar the stock price moves lower…you lose a buck on each share you own.

You see, when you start talking about time decay and volatility, the average investor starts looking for the exit signs.

They simply don’t have the time to “crack the code.”

However, what if I told you that options can be made easy to understand (just like buying a stock is)….that we could get a better return on our capital by using them as an investment vehicle (not a trading vehicle).

You know what? You can, but you’ll need to keep an open mind. For a second, forget what you think you know or heard about options.

Back in late January, I had a conversation with a woman on Twitter about a stock. She wanted to know my thoughts on Fusion-IO (FIO) heading into earnings.

Initially, I made the mistake by using a little too much option jargon, assuming she was raw and ready.

(Note to self: Avoid using terms like trade structure and implied volatility to non-option traders)

Onward.

Now, of course, I was tracking the options order flow in FIO for a couple weeks and had noticed that the bias was towards the upside…and, as usual, was happy to share this information with her.

First, let me say, she was pretty savvy and aware that the stock had a high short interest (a good portion of the market participants were short the stock, if it were to rip higher, the shorts would have to cover, which would add more buying pressure).

However, holding a position in front of any event can be risky business.  But still, she had a hunch that it might trade higher and was willing to take on that risk.

The stock was trading at around $9.40 a share.

Now, here we had a stock investor that was unaware that options could be used to make the same investment idea…but only better.

However, it turned out that FIO reacted well to the earnings news. The stock traded as high as $10.92 the day after earnings.

As I mentioned earlier, having a position ahead of an event is risky. You know, in this case it worked out well for her.

She was able to book some profits…sit on the sidelines and wait for a better price to re-enter (if the stock price were to fall back down).

Although she monitored options activity and considered it a useful tool of hers, she never trades options because of their complexity.

Again, if you’re using options to speculate…they can leave you in a failing state of befuddlement. On the flip side, using options as an investment is simple, easy and straightforward.

I tried to explain that by using options as an investment vehicle, she could get a better return on her capital.

Why an investment and not a flamethrower to speculate with?

Well, let’s break it down. The two simplest ways to make a bullish bet on a stock with options is to buy a call or sell a put.

Now, when you buy a call, you’re paying a premium, so not only does your opinion on direction have to be correct, you’ve got to be precise on the volatility and timing.

That’s a tall task for the average investor, let alone “pros” that are on the front-line trenches.

On the other hand if you sell the put, you’re obligated to buy the stock at a cheaper price than what it’s currently trading at…

And if the stock trades higher you’ll collect the entire premium from selling the put option.

Wait, what just happened here?

We’re collecting premium on a stock we want to own, if the stock trades higher… we make money from the premium collected. Get this,

If the stock trades lower… we own it at an even better price (not only do we define the price we want to own the stock, but we collect a premium…so our price is going to be even better than the price we wanted the stock).

We simply subtract the premium collected from the price we want to own the stock.

(Don’t worry if it doesn’t make any sense yet, I’ll show you an example shortly of how it all works.)

We’ve now turned options into an investment vehicle. In addition, we’ve eliminated the concerns that most investors have about options…that are, getting the timing and volatility aspect correct.

In fact, they now work in our favor! It shouldn’t come to a shock to you that the Oracle of Omaha utilizes this option investment strategy “on the reg”.

Let’s face it. The glamour is in trading, not investing. Whenever you hear about options, you’re told stories about traders who turned a little bit of money to a lot…or hedge funds that used so much leverage they blew up.

Think about it. Why would the Oracle of Omaha call derivatives financial weapon of mass destruction… but at the same time sell puts on securities that he’s willing to own?

In other words, option leverage is a double-edged sword, used in an abusive manner it can cause a great deal of harm…used responsibly, it can be an excellent way to generate income. Pretty obvious, isn’t it?

Now let’s go on.

So she sold her stock, in hopes of getting back in at around $9.90 (if it ever reaches those levels again).

Well, for one thing, I knew I was talking to an investor.

However, I still had to break-down that wall of belief that options are complicated trading instruments.

So I decided to blast out some real life numbers, hoping she’d see how wickedly effective this method of option investing is.

Scenario:

FIO is trading at around $10.86 per share.

Investor would like to buy stock if trades around $9.90

By using stock there are only two possible outcomes:

1) The stock never trades that low again, which means they never re-enter or stubbornly get back in at a higher price.

2)   The stock does trade at their desired price level and they’re back in.

Using Options:

At the time of the discussion, The February $10 puts were quoted at a premium of 40 cents apiece (29 days until the option contracts expire).

Now, if the investor sold 10 contracts at that price, they’d collect a total premium of $400.

Comparison:

Stocks: If the stock never trades below $9.90… they would miss their opportunity to get back in.

Options: If the stock never trades below $9.90… the option investor can keep the entire premium of $400. Now, if you want to get real technical, the break-even point on the option investment is $9.60. That is $10 minus the 40 cents of premium collected. Again, this is a superior entry price.

Advantage: The Option Investor

But wait…it gets better.

By using options, we’re using less capital and hence we can expect a better return on investment. For example, 10 contracts is the equivalent of 1,000 shares. At $10.86, 1000 shares will run you $10,860.

In a non-IRA account with margin, if you sold to open 10 put contracts, which would be equivalent to 1,000 shares. The broker would only hold 20% of this amount.

Let’s assume you’re required to have 20% of this amount (for margin) to sell the 10 put contracts.

$10,860 x .20 = $2,172

If the stock doesn’t trade below $10 on the expiration date, you’ll keep the entire $400 in premium.

In 29 days, that’s a return of 14.7% … and if you wanted to annualize those returns, it’s a whopping461.9%

Advantage: The Option Investor

Final Score: 2-0

Winner:   The Option Investor

All in all, using options to speculate on directional bets could leave you at the deep end of the pool. On the other hand, if you’re an investor, using options can be a great way to generate income, get a better return on your investment… and price for a stock you’d eventually want to own.

Can you imagine that? I know it seems unbelievable but facts are facts!

By the way, on February 22, 2014, those $10 puts in FIO expired worthless. Not only that, but the stock has yet to trade below $10.10 (since that conversation occurred).

What to do next?

Leave a comment below and let me know what you’re still struggling with when it comes to options.

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