Options – Back to Basics

In this column we cover many aspects of options trading, from very basic options strategies to some pretty advanced topics. Many people are drawn to options precisely because there is so much to know about them. It’s an intellectual challenge and a source of fascination. If you are interested in solving puzzles, they can provide an endless supply. There are many ways to make a profit and have fun at it. If you are an engineer, accountant, programmer, mathematician or would like to be any one of those, you have the type of mind that likes options and can make them work.

But for all their cool attributes – leverage, low cost, multiple strategies – options don’t perform magic. They work really well only when you have a clear idea about what the underlying stock price is most likely to do.

The simplest option strategies – buying calls when you’re bullish or puts when you’re bearish – are designed to make large profits on a small risk when you pick the right direction. They are straightforwardly directional trades. We expect to make money with them only when the stock goes in the direction that we anticipate, and in fact we can do just that.

We can enhance the results of these simple directional options strategies by taking into account time decay and stock price volatility. These are the two additional dimensions that only options have. Those dimensions are the secret sauce that makes option trading different. Still, no amount of finesse in analyzing time or volatility can make up for picking the wrong direction.

Some people hear things about options that have a grain of truth but are misleading. For example, they may have been told that selling options (short) is far more likely to be profitable than buying them. That is sort of true, in a way, but with several caveats.

The sellers of options can make a little money even if they are a little bit wrong about the direction of the stock, it is true. But the flip side is that those sellers can also lose a lot of money, many times more than they could have made if they are very wrong instead of just a little bit wrong.

Selling options typically produces mostly modest winning trades, punctuated by occasional large losses. In this way it is like the insurance business. An insurance company takes in many small premiums and occasionally has to pay to rebuild a house that burns down. As long as they take in more in premiums in the long run than they pay out in claims, they will be profitable. Their edge is in knowing the probabilities of houses burning down. Or looked at the other way, of their not burning down (in which case the insurance company makes a profit).

Our edge as option traders comes most importantly from being able to determine with a high degree of accuracy, in advance, at what level a stock’s price is likely to change direction. Being skilled at that is just as important when trading options as it is when trading the stock itself.

The Online Trading Academy Core Strategy teaches exactly this skill. For any trader in options, building that skill is the indispensable first step.

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