The four biggest mistakes in option trading

Years ago I had a friend attend a seminar on options in which he learned to buy out-of-the-money options on commodities and keep buying them until he hit the jackpot. Theoretically, the one big win would pay off all of the losses and add a hefty profit.

That strategy is pure gambling according to Jay Kaeppel, author of The Four Biggest Mistakes in Option Trading. The four are 1) relying solely on market timing to trade options, 2) buying only out-of-the-money options, 3) using strategies that are too complex and 4) casting too wide of a net.

Options and futures originated in the 17th century in the Dutch Republic to provide farmers a way to protect themselves against falling prices at harvest time and as a way for processors to protect their businesses against shortages caused by drought or disease. Options are still a good way to protect all kinds of assets, including shares of stocks. For example, a simple strategy for protecting one’s nest egg from a market collapse is simply to buy put options on an index of on the stock of specific companies. If the market declines, the option should increase in value enough to make up for the loss in the stock portfolio.
But you need to know what you’re doing. Don’t just throw money at options and hope for the best. For example, buying long term options, those greater than a year out, and at-the-money (the strike price is the same as the price of the stock) or in-the-money (the strike price of the option is above the price of the stock for a call and below it for a put) will give you better chances of success from the strategy.

Kaeppel’s mistake #1 above has to do with the price of the option. He isn’t against market timing, which he considers essential, but against using timing alone. Investors must consider the prices of options (the premium) in the same way they consider the price of a stock. Options can be over and undervalued just as stocks can. Options become overvalued when the volatility of the stock underlying the option is high. Even if the stock price doesn’t change, but its volatility does, the price of the option for that stock will change because volatility makes up a good portion of the option price. So if you buy an option when volatility for the stock is high, you could lose money when volatility collapses even if the stock doesn’t change prices. So pay attention to volatility.

Buying only out-of-the-money (OTM) options seems like a great idea. After all, they’re very cheap. But they don’t move in step with the price of the stock, either. Options at-the-money (the strike price of the option is the same as the price of the stock) will only make about 60% of the move of the stock price. Selling, or writing, options out-of-the-money is often a good idea, but when buying it's almost always better to buy in-the-money.

Mistake #3 is obvious: keep strategies simple. As for #4, an investor needs to understand the market he is dealing with, so pick a few markets to follow and learn them well so you'll have a better chance of timing market direction.

Anyone who has lost money on options or wants to begin using options should start with Kaepel’s book because it’s only 85 pages. But don’t stop there. Move onto Options as a Strategic Investment 5th edition by Lawrence G. McMillan. McMillan’s book is over 1,000 pages, but it’s well worth the read because he describes various strategies, as most books do, but he goes the extra distance and explains the risks involved and how to respond if the market doesn’t agree with your strategy.

Stock markets that trade in a narrow range as the US market has for several years are difficult to make money in because there is  little price appreciation. The beauty of options is that the experienced investor can make money selling options when the market trades sideways for a long time. But don't get greedy and try to hit home runs every time. Pay attention to volatility, buy in-the-money options to keep leverage low and the probability of profits high, and add income from options to your dividends.