Cheap Isn’t Always Better

I’ll be traveling to Winnipeg today on behalf of the Exchange to facilitate a workshop for aspiring, active investors. I have had the opportunity to present to this group on several occasions and despite the anticipated cold weather, I know the crowd is always warm, very interactive and hungry to learn.

That said, one of the topics I will be focusing on will be options trading mistakes to avoid. I always think that this is a great topic, because regardless of how well you understand the basic trading principles of using options, it’s good to be reminded of some of the pitfalls that stand between you and trading and investing with options successfully.

While there are many common mistakes (I cover 10 in my presentation) I want to focus on one that proved to be an expensive misunderstanding for me when I first started options trading. In fact, if you are interested in the entire breakdown of the the most common mistakes, check out this video found at M-X.TV
Avoid The 10 Most Common Option Trading Mistakes

The Misconception

There tends to be a misconception that buying cheap options is the best way to leverage capital and a surefire way to guarantee a home run on a stock that is expected to make a substantial move.

While it is true that options offer a trader the ability to substantially leverage their capital with a limited and identifiable risk, it is important to understand that options are cheap for a reason. Often time’s novice traders overestimate their probabilities of being correct and underestimate their risk.

It’s all about the probabilities

I am going to assume that readers already have a basic understanding of terms such as strike price and expiration date as they relate to the options market. If not, here is a link to an Introduction To Option Trading video.

In order to truly understand the importance of probabilities, aspiring option traders must recognize that options are priced based on the expectation of whether a stock has the potential to trade beyond the selected options strike price within a specified time frame.

For example, let’s take a look at call options on Blackberry Limited (TSX:BB) Currently the shares are trading at $11.70.

To look at it from the perspective of time:

Note that the more time allocated for the stock to move towards and beyond $12.00, the more expensive the option contract. This is because the market is pricing in the stock’s average Historical Volatility.

Historical Volatility is the amount that a stocks share price has been fluctuating over a period of time. For more information on volatility check out out Patrick’s blog Trading Volatility. The price of the November contract is suggesting that there is a moderate chance that shares of BB are going to trade above $12.00 by the November expiration based on its historical trading behavior. Not a good bet in my books. By allocating more time, the trader has a higher probability of being correct. Remember, if the move happens in a day, you can still close your longer term option out for a profit. However if the move happens over a 3 month period, the November option will be long expired and a full loss potentially realized.

Because we are focused on trading shorter term price movements on volatile stocks, we tend to focus on selecting 2-3 months out for our expiration dates. This is with the expectation that we are likely going to be out of the position within 1 or 2 weeks. Despite the fact that we have a shorter term outlook, we realize that our anticipated price move may not happen immediately. By allocating more time than anticipated we believe we are “erring on the side of caution”

You also don’t want to purchase too much time either. As a general rule, slower moving stocks need to be given more time for the price to reach the anticipated level. You also must consider whether you are an active trader with a short term outlook or whether you are more passive and have a longer outlook.

Rule of thumb

Know the stock you are trading options on, determine your outlook, select the appropriate time frame and manage the position accordingly. And when in doubt GIVE YOURSELF A LITTLE MORE TIME!

As for my lesson

I did all of the research, analyzed the price chart and was confident the stock was going to move. I wanted to get the best bang for my buck so I chose a cheap, short term option. Long story short…I was right about the stock but wrong about the time I selected for my option contract. 1 month passed, my option expired worthless and then the stock took off as anticipated. In hindsight, I could have purchased fewer contracts but with more time. This would have tipped the probabilities of being correct more in my favor and allowed me to profit from my original outlook.

Remember, learning to trade and invest with options is an ongoing journey and we learn from our mistakes. Be sure to analyze your losses to see if you took all things into consideration. We are dealing in a business of probabilities, so if we can filter out mistakes such as the one discussed here, we tip the odds a little more in our favor.