As technology has made stock trading easier in recent years, more traders have become comfortable calling their own trading shots rather than relying on a financial advisor. Unfortunately, few traders that manage their own investment portfolio have a background in finance, and many get lured into trading complicated financial products after hearing stories of other traders making huge gains overnight.
One of the more complicated types of financial products are stock options. A stock option contract is an agreement that gives the buyer the right to buy or sell shares of a stock at a given price on a given date in the future. Each option contract typically represents 100 shares of the underlying stock, so it’s easy to make large gains or losses in short amounts of time.
There are plenty of anecdotal stories in the online investing world of options traders making 1,000 or 10,000-percent gains in a matter of days. Much like stories of gamblers who hit the jackpot at the local casino, these stories may very well be true. Unfortunately, they are far from typical.
A past study of Chicago Mercantile Exchange data showed that about 75 percent of all option contracts sold over a three-year period expired worthless. Many new option traders don’t fully understand exactly what they are in for when they buy stock options and don’t know the smartest ways to trade them.
For starters, traders have to be much more accurate with their predictions to turn a profit buying options.
When traders buy shares of stock, they are making a bet that the stock’s share price will go higher at some point in the future. In order for stock buyers to profit, they only have to get one prediction correct – the direction the share price will move.
Like a stock buyer, an option buyer must first correctly predict the direction in which a stock will move.
While stock buyers can wait patiently for years before they sell, an option buyer must be correct by the expiration date of the option. Every day that the option holder waits, the time value associated with the option diminishes.
Finally, option sellers don’t give away contracts for free, so buyers usually have to pay a hefty time premium on their options. That means that the underlying stock’s share price must move in the correct direction by at least the value of the time premium before option buyers break even on their investment. Many times, when a stock makes only a modest move, option buyers can be correct about timing and direction and still lose money on their investment.
SamurAI is a company dedicated to using artificial intelligence to integrate option trading strategies into investors’ portfolios. Founder Leav Graves says most investors simply don’t know how to trade stock options optimally. New options traders tend to make dangerous mistakes.
“New traders often over-leverage themselves,” Graves says. “For example, one in-the-money call on Apple (ticker: AAPL) represents an $11,600 asset. It is not uncommon to see new traders do 10-lot trades representing $112,000 without realizing their portfolios can’t accommodate a trade that size.”
In addition, Graves says many traders opt to buy short-term options because they are cheaper, but these traders often underestimate how long it will take their long-term thesis to come to fruition.
Simon Curio, founder of SimonSaysOptions.com, says options serve investors well when they are used for their original purpose.
“Hedging is what options were created to do, but somehow they became the weapon of the speculator. Now they are mostly associated with get-rich-quick schemes where gurus claim to make millions with only a small amount of money,” Curio says.
JJ Kinahan, managing director of client advocacy and market structure for TD Ameritrade, says the 75 percent statistic actually works in favor of option sellers. “For many retail traders, that’s just fine. Many will sell out-of-the money covered calls and pick up the premium from when it expires worthless,” Kinahan says.
Michael Sincere, author of bestselling book “Understanding Options 2E,” says this type of option selling is a bit like operating your own personal stock rental service and can be very profitable.
“Many long-term investors sell covered calls, a conservative option strategy that generates income from stocks that you already own. In a way, you are renting your stocks to option buyers and receiving compensation for doing so,” Sincere says.
Market gamblers looking to get rich buying options will largely be disappointed with the results. However, Curio says smart investors should flip the tables on these gamblers. “The best thing to do is…
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