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.

Cover Your Assets

The market isn’t likely to go much higher the rest of this year because as the last post showed it has already out distanced profits by quite a bit. So unless profits improve dramatically, the best an investor can hope for is a flat market with the potential for a major drop. But what if the market does reach higher levels and sets new records as it has several times this year?

Covered calls are great tools for situations like this. A covered call is a strategy for an investor in which he sells or writes call options in the stocks he owns. By selling a call option, the investor is selling to another investor the right to purchase the stock the seller owns at the strike price. The strike price should be higher than the price of the stock at the time of the sale of the option, or what is known as an out-of-the-money (OTM) strike price.

The strategy produces a win/win situation for the seller of the option when the market has risen to nose bleed heights. If the market remains flat, the seller of the option keeps the premium. If the market falls, the premium replaces the lost value of the stocks and gives the investor time to sell.