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Options Trading: Avoiding the "No-win" Strategy

Posted March 4, 2010

Topics: Finance & Investing

Believe it or not, some traders set themselves up to lose in their option strategies, no matter what happens. With about 75% of all options expiring worthless or losing money, you can’t afford to set yourself up. A “limited win” or “limited loss” strategy makes much more sense.

Here’s how it works. You buy an option hoping that the premium value will rise. To keep the cost down, you picked a two-month call just out of the money and paid 3 ($300). All you need to get to breakeven is a three-point move in the stock; and any price change above that will be all profit. Remember, though, this movement has to occur within the next two months and before the call expires.

The odds are against you. In this strategy, you have only allowed for price movement in one direction, upward. In reality, though, you know that stock prices tend to move in both directions, and when price moves strongly upward, other traders take profits and force the price back down. The price back-and-forth makes it less likely that a stock’s price will consistently net out at three points higher in only the next eight weeks. It can happen, but it usually doesn’t.

So even if you are willing to take this risk, figuring that for $300 you could double your money, can you still lose? If you set yourself up with a “no win” approach, the answer is yes, you can (and will) lose.

If the option’s value declines due to either a fall in the stock’s price or just from time decay, you are likely to tell yourself you have to get back to breakeven before you can close. But if the price does return to breakeven, a different voice comes through, telling you the premium value might continue to rise and you fear losing out of profits; so you take no action.

If the option’s value rises, you could take profits, but the inner voice now tells you to hold off because the value could keep rising, and you don’t want to lose out of more profits. So you take no action. As time decay sets in, profits evaporate and you’re back to the first inner voice.

The question you should ask is this: Under what circumstances will you close out this long position? The “no-win” approach allows no escape either with profits or with losses. You are going to lose every time if you listen to the inner voices that mislead you.

There is a logical solution. Just set a goal and bail-out point for yourself and then follow your own rules. For example, if you pay a net of 3 ($300) for a long option, decide in advance that you will sell when one of the following two events takes place: First, sell if the value rises to $450 or more, representing a 50% gain ($150 on a risk of $300). Second, sell if the value falls to $225, representing a 25% loss ($75 on a risk of $300). You take your profits or cut your losses, the only strategy that really makes sense.

So what if you lose out on future profits now and then? Your overall option trading return is always going to be higher if you set rules and then follow them.