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Why I Avoid Trading Options When Possible

September 10, 2013
It’s a question that I’ve gotten many times in the past. If I believe so much in a stock like Facebook, why not buy a call option instead of buying the stock? The potential gains (and losses) are so much greater. It’s easy to understand why. If I buy for $5000 of Facebook, I’ll basically own about 100-150 shares.

However, by buying call options, I could have an exposure that would be 10 times the number of shares. It’s certainly tempting and I obviously would have done extremely well had I done that instead of buying the stock. So yes, in theory it makes a lot of sense and if you are right on calls like that one, buying options will end up making a lot more sense.

There’s More To Equity Risk In Options

The big problem of course is that when you trade an option your performance depends on much more than the stock’s price. The option will also move depending on changes in interest rates, dividend expectations and volatility. Those factors are not minor. I personally try to simplify my personal trading and trading volatility clearly does not fit that model. I’ve had the pleasure of working with many options traders and I can tell you one thing. They love trading against retail investors that end up making trading mistakes on options.

Trading Options Is Extremely Expensive

One thing that many retail investors don’t realize is how expensive trading options ends up being. Not only do options need to be rolled once they reach expiry (adding commission costs) but the spread is often much more significant. If you buy a stock worth $40 like Facebook, the bid-ask spread will usually be $0.01. Options that have much smaller prices trade at larger spreads. Over time, that cost adds up and can become significant.

There Are A Few Instances Where I Do Trade Options

In some cases, options really are the best option. Some stocks are very expensive to borrow so having a high delta option (that is in the money and moves very closely to the stock) so using options can work well. In other cases such as covered call strategies, I’ll leave the option selling to pros by buying covered calls ETF’s for example.

Do You Trade Options? If so, under which circumstances?


Rating: 2.0/5 (9 votes)

Comments

JonesC
JonesC - 7 months ago
Intriguing article. However, as a new person, I'm curious about something. Why are options risky in the following scenarios?

1. Buying options on a stock that is just revealed to have been bought by Warren Buffett?

2. Buying options on stocks that are listed within a portfolio of a mutual fund/hedge fund manager who has achieved 25% average return over the last twenty years? Keep in mind, in this person's portfolio, almost all stocks listed in it go up 5-30% within the first three months of him buying them or adding to them.

3. When a new company like Apple are releasing a new product like the iPhone9 and all the zombies are in line waiting for it on release day.

I might be able to understand not buying options for scenario number three because of the product failure or disappointment aspect, but to me, I can't see why option would be risky in the first two scenarios. Can someone explain why I'm right or wrong?
lflaksin
Lflaksin premium member - 7 months ago
You are so unbelievably wrong, it's almost comical. Options allow you to control the direction of a stock by putting little money down. You can buy a 2015 $30 calls on $FB for under $16. So you are only paying $2.50 in premium above the intrinsic value of the option and you put only 37% (16/43) to control the stock. Yes, you have to account for the dividends, but guess what... You can sell October (38 days to expiration) $47 calls for a $1 per contract. So if the stock rises less than 8% in 38 days, you just shaved $1 off that premium, and if it does, you can roll the short calls up and out in time never having to give up the $1 premium, or just close out the trade making good 20 - 30% in 38 days.

And I haven't even touched upon short put spreads, doing ratio spreads and other techniques.... It's not about being

Costs... I pay 0.75 per contract (100 shares)... I don't think it's very expensive.

My friend, you have to use a filter next time you experience sudden urge to write an article next time.
Dr. Paul Price
Dr. Paul Price premium member - 7 months ago


You can avoid trading options 100% of the time by simply not doing it.

Where does "When possible" come into it?
batbeer2
Batbeer2 premium member - 7 months ago
double post - deleted
batbeer2
Batbeer2 premium member - 7 months ago
>> I might be able to understand not buying options for scenario number three because of the product failure or disappointment aspect, but to me, I can't see why option would be risky in the first two scenarios. Can someone explain why I'm right or wrong?

In order to figure out the answer to that, you first have a crystal clear about the definition of risk. If we define risk as "the probability of losing 100% of your investment", then then it's simple:

- With the stock, you lose 100% if the stock price ends up at zero.

- With the option, you lose 100% if the stock price ends up below the (non zero) exercise price.

Your example of the Buffett stock is interesting. I have seen some of his picks drop 50% in months. I haven't seen any go to zero.

In short, options are just another form of leverage. You can get higher returns at the risk of losing it all. You go that route and at some point you will lose it all.

Ask a dozen 50-60 year old guys you know who aren't active in the stock market. You will find a few former (options) traders who claim they could have retired rich if they had just quit in H1 1987 or 1999 or.... 2008. They were wiped out by unexpected volatility, faced some margin calls and had to promise their wives never to touch a brokerage account again. They don't talk about it much so you wont know till you ask them. The rest of the bunch just aren't very interested in stocks. Never were.

The latter group obviously doesn't include you. Avoid becoming one of the former.

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