Beware of This Trap When You Trade Options
The promise of bigger and quicker percentage gains compared to vanilla stock trading makes options very intriguing. But for people who are starting out, it can be a daunting task to choose the right strategy that fits them.
The strategies range from simple to complex. Whatever strategy you choose, it will come with its own pros and cons. The key is to understand what they are. Today, let’s take a look at the simplest example.
The simplest strategy is to just buy a call or a put. If you think a stock will go up, buy a call. If you think it will fall, buy a put. But pay careful attention to your timing. It’s where things can go terribly wrong for you.
Timing Is Important
If you are right about the stock, and the stock makes a big move in your favor, your option position will likely give you a nice profit.
The problem with this un-hedged strategy is that if the stock goes in the opposite direction, you could lose a big chunk, or even all, of your investment.
Worse yet, since options have an expiration date, time works against you. Therefore, even if you are right about the stock direction within the time frame of the option, if the stock doesn’t move fast enough, you could still lose money.
HAL ended last Friday (December 13) at $23.99, so technically you were correct that the share price would improve. But the January 17, 2020 $22.50 call closed trading Friday at $1.94. You are down 18% even though the underlying stock rose more than 4%. What gives?
Time Decay Hurts the Option Buyer
Time decay is a big reason. Let’s see why.
To keep things simple, we will only consider the two primary factors of the option’s price: intrinsic value and time value.
When you bought the call, its intrinsic value was $0.50. This is because if you exercised the option, theoretically you could buy at $22.50 and sell at $23. This implies that the time value at that moment was $1.87 ($2.37 – $0.50).
Flash forward to last Friday, December 13. The option’s intrinsic value had risen to $1.49 ($23.99 – $22.50). This means the time value had decayed to $0.46 ($1.94 – $1.49) and that’s why you are sitting in the red even though the stock is at a higher price than when you first bought the option.
How The Stock Comes Out of Gate Matters
Secondly, although HAL did rise between July 31 and December 13, its action right after you bought the call was not favorable. For various reasons, oil prices fell in August, and so did energy stocks. Just one week after you bought the call, HAL had fallen to $19.65. The call had crashed to $0.99.
This implies that in the first week you lost only a bit of time value to $1.86 ($22.50 – $19.65 – $0.99) but the drop in the stock price put you in a deep hole.
As you can see from the example, buying a simple straight forward call or put can bring some big ups and downs, depending on how the underlying stock moves.
This is why many experienced option traders use a combination of options to manage risk. The use of just two options can help to keep the downside contained. We’ve covered these various option-trading strategies in the past and we will have more to talk about in the future.
Nowadays discount brokers like Schwab and TD have eliminated commissions on most stocks entirely. The cost of trading an option has fallen significantly and shouldn’t be more than $1 per contract.
Thus, one of the main drawbacks to using multi-legged option trading strategies—higher trading cost—is much less of an issue.
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