You WILL Lose Money in Options Trading – Unless You READ THIS FIRST!
Why 90% of Options Traders Lose Money – The Information in This Article Can Help You Be Part of the 10% Who Don’t
The majority of new options traders lose money. It’s a reality (or at least pretty close to this number). The good news is that we can help you reduce your risks of this happening to you.
Options traders don’t have an innate ability to pick winners. The majority of successful options traders follow rules that help put the odds in their favor. These rules give them an edge.
The Usual Story
Options are leveraged assets, but the leverage here is not the same as borrowing money on margin. When you buy calls or puts, the most you can lose is the premium you pay. Small premiums are not an issue for most investors. But when you pile on several options contracts, your wealth can take a sizeable hit.
Beginners often load up on “cheap” options, expecting the underlying stocks to make sizeable moves before expiration. That’s a recipe for financial disaster. One wrong move in the stock or not enough movement before the options expire, and those cheap contracts become worthless before you’ve had a chance to react. Even “cheap” options become expensive when you buy too many of them.
Stocks can make big moves in short periods. But the chances of that happening are slim, and most beginners don’t understand this. It’s a fundamental concept that you must learn before you start trading options.
You can figure out if a stock you are interested in buying options on may make significant moves. Download several years of price data for those stocks. Track the monthly changes (both up and down).
Another fact to consider is that options on volatile stocks will not be cheap, and volatility is required to move options in a particular direction. That means the cheap options you find will have little to no chance of going past the breakeven point needed for your options trades to be profitable.
What is the right price for options, and as necessary, what expiration date should you choose? The answers depend on what your expectations are for gains and your appetite for risk. The most expensive options overall will be the at-the-money options, which are when the strike price is on or close to the underlying stock price. The further out you go in expiration dates, the more expensive the options contracts will be, as well.
Remember that in-the-money options have intrinsic value, which is the stock price difference from the strike price. If the value of the stock stayed the same for the duration of the options contract, the intrinsic value would not change. Options also have a time value, which is the component of the options contracts that decay over time..
Finding the right balance on price/expiration date often involves assessing the probability that a stock will be substantially higher within a predetermined time. You can use that assessment to determine the price and time to expiration that you want to use.
NOTE: If you are going to use the concept of tracking monthly moves of a stock, make sure you go back several years and take an average move instead of absolutes. There can be periods of extreme volatility with certain stocks. Just because a stock acted in a certain way for a few months does not mean that pattern will continue each month.
A Few Examples
Let’s say MRVL is trading at $79 and you want to participate in the upside of the stock without tying up $7,900. You feel bullish on the market and on the prospects for Marvell. You buy a slightly in-the-money call with a $75 strike price, expiring in six months, for $13.50 per share ($1,350 total).
With options trading, you need to determine your breakeven point. For this trade, that amounts to $88.50 ($75 strike + $13.50 premium). The stock must be higher than $88.50 at expiration for you to realize any gains in your options position.
If MRVL rises to $100 by expiration, the call has $25 of intrinsic value, which is the difference between the stock price and the strike price. That’s $2,500 for the contract, giving you a profit of $1,150 after subtracting the $1,350 premium. And you could either exercise the option and sell the shares at market or sell the option contract itself to realize the gain.
Newbie options traders often get tripped up (and lose money) with this next scenario.
They start by searching for the cheapest option premiums listed, which are almost always on the contracts with the shortest time until expiration and strikes way above (or below for put options) the current stock price.
Let’s revisit our Marvell (MRVL) example but with a different trade setup. The price for a September 19 expiration, with a $110 strike price, is trading around $0.49 per share. Options contracts usually cover 100 shares of an underlying stock. For this scenario, that’s $49 for the whole trade (not including commissions).
When you see how cheap the trade is, you start thinking how you can boost your gains by increasing the number of contracts. Purchase 10 contracts for $490, or go all in and buy 25 contracts for $1,225. That’s even less than the total amount from the first scenario ($1350)! Just think about the returns you’ll get if this trade goes in your favor!
The issue here is that the trade dynamics for this second scenario are far worse than our earlier, more conservative example ($75 strike, six months until expiration). Marvell would need to reach $110.49 by expiration for this trade to be profitable. That’s more than a 40% jump in about a month.
Without a major, unexpected catalyst, the probability is close to zero. And while $49 may feel like a small bet, scaling it up to $1,225 is still $1,225 gone if the option expires worthless, which is what often happens in trades like this. You are not positioning the probabilities to be in your favor, and options trading is about doing just that.
Will the first scenario make you money? There’s no way to tell until the six months pass. But the chances of you making at least some money on the trade from this first scenario are much greater than making money in the second scenario.
Successful options traders position the trades to put the odds in their favor. They don’t make money on every trade, but with proper money management and probabilistic positioning, their wins overtake their losses by a wide margin.
How to Get Started
A good first step is to paper trade options. While paper trading won’t capture the real emotions of actual trading, it will help you learn the dynamics of how to make options trades, without risking any of your capital.
Some people are against paper trading for the very reason that there is no skin in the game. But as long as you understand this constraint, you should be okay when you make real trades.
You can even construct trades with the two scenarios described in this article and see how they both pan out.
One Caveat
Some people never traded options and have no intention of ever doing so. Many of them build successful portfolios made up of stocks, mutual funds, and ETFs. Options can be risky, and without understanding how they work, the risks can be significant. If you decided after reading this article that options trading is not a good fit, that is within your rights. You can take comfort knowing that a non-option-based portfolio can still bring you financial success.
Final Thought
Options trading tends to be more complicated than stock investing. Even learning how to do it correctly does not reduce this complication much at all. Options can amplify gains, for sure, but they require more of your time. Whether that time is worth it, only you can answer.
Even more importantly, if you treat options as a craft to be learned rather than a lottery ticket, you give yourself a real shot at being in the 10% who actually make it.
