For most options traders, the entry into this world is through the long strategy. It is considered the most basic and easy to understand. The sequence--buy, hold, sell--is familiar and logical. However, this is also one of the highest-risk options strategies. Approval by brokers to trade more advanced but lower-risk strategies is not given easily; so paradoxically, new traders are required to accept higher risks.
Long strategies are not as simple as they appear at first glance. Remember:
1. Risk is limited. but the limit is 100%. Buying options allows you to control 100 shares of stock for each contract purchased, and that is an alluring form of leverage. The good news is that you can never lose more than what you pay for the option, even though it gives you control over 100 shares. The bad news is that if you lose, it is a 100% loss. With this in mind, risk has to be managed carefully. You should limit the dollar value of option speculation.
2. Most options expire worthless. About three out of every four options never become profitable. That means it’s a 4-to-1 bet against you to buy calls or puts. You are likely to lose your cash 75% of the time. Why? Because of time decay. Some portion (often most) of the long option’s premium consists of time value, and this evaporates as expiration approaches. Even if the underlying stock is moving in the desired direction, growth in intrinsic value is offset by decline in time value.
3. Buying options is the first strategy you are allowed to undertake, but it is also one of the highest-risk strategies. For example, writing covered calls is a very conservative strategy but only more experienced options traders are allowed to do this trade. Why? Because shorting options is more sophisticated and advanced, and demands greater knowledge. At the same time, it has less risk.
4. You have to remember the rules of automatic exercise. If you let expiration day pass by and your option is in the money even only a bit, it will be exercised automatically. You might think you are going to let the option just expire because you have lost most of your money, only to discover that your broker exercised your position. In other words, know how the trading rules work and avoid unpleasant and unexpected surprises.
5. The basic strategy is usually thought of solely as speculative move or as part of a rudimentary swing trading strategy. But there are many other reasons to buy options, including using puts to insure paper profits, setting up a contingent stock purchase or sale in later months, or exploiting momentary big changes in market prices (swings). It pays to know about all of the possible strategies before simply jumping in and putting money at risk.
6. The dollar amount you use to speculate in options should be very limited. Buying rich options makes it very difficult to create a profit and, in the event of a loss, those cheaper options create far less in net losses. Keep a clear view of potential profits and potential losses.
With option speculation, as with any trading strategy, it makes sense to have more knowledge and experience than you might need just to execute a trade. You cannot expect 100% success, but beating 50% is going to put your trading experience in the winning column.
Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE blog and to the Seeking Alpha blog.