This, the eight post in my ten biggest mistakes in option trading series, features my first ever guest writer. Options educator and author Mark D Wolfinger from Options for Rookies kindly agreed to help me complete this series. Mark’s recent book is The Rookie’s Guide to Options.
Now it’s over to Mark.

Option Buyers Beware

Most option rookies begin their careers by buying an out of the money put or call, hoping – more likely expecting – that the stock will magically soar or dive, earning that rookie trader a good-sized reward.

When a few weeks pass and the option expires worthless, the rookie is not only disappointed, but often perplexed.  The stock underwent a very nice rally in just 4 weeks – moving from 40 to 48.  He/she owned call options.  How could the trade not make money?

The bottom line is that it’s difficult, at best, to prosper when buying options.  Many beginner books suggest buying options as the ideal learning strategy, but I find that to be very poor advice.  We all know that the majority of professional money managers cannot beat the stock market, yet they are handed hundreds of billions of dollars to try to do just that.  And, they charge their customers a fee for under-performance.  The fallibility of money managers is well known, yet the majority of individual investors are confident that they are different, and can beat the market.  There’s plenty of evidence to show that individuals perform no better than the market averages, and many accept that as true and buy index funds.  But not all investors accept the facts.

Bucking those odds is bad enough.  But to make matters even worse, investors with market-beating stars is their eyes love the idea of buying options.  After all, the prospect of spending a few hundred dollars to control several hundred shares of stock (that’s leverage) allows them to the chance to make as much money as investors with larger bankrolls.

To win the option-buying game, they must not only pick the correct direction for the stock – and as already mentioned, that’s already too difficult for most – but the timing must be right.  That makes the probability of earning a profit even lower.  Options have a limited lifetime and if the trader is not sufficiently accurate in timing the market move, there’s no payoff.  Just more losses.

If that combination is not bad enough, there’s also the requirement to make a good guess as to the size of the market move.  I’ll agree that if the trader buys in-the-money options, this becomes less of a factor.  However, option-buying, leverage-seeking traders – especially newcomers to the options world – prefer those low-delta out-of-the-money calls and puts.  And that makes guessing the size of the move imperative.  True, options should not be held until expiration day, but if the underlying stock doesn’t move far enough, fast enough, then the option’s value can quickly fade away.

Looking at the example I used earlier, the trader sees the stock zoom 20% in one month and all the investor has to show for making a good stock prediction is the equivalent of a torn-up pari-mutuel ticket.  The ‘horse’ just did not have enough to finish the race.  Out of the money options are useless once expiration arrives.  The trader bought calls with a strike of 50 when the stock was 40.  The price was low, but it was still too high.

It’s a difficult task to make money buying options.  The incentive to try is the chance for big score.  It’s possible to turn $1,000 into $10,000 in only a few weeks.  And that possibility is what keeps hope alive.  I’m not telling you it cannot be done.  Traders who have proven they have a good track record when it comes to picking direction or timing the market may be able to earn a very good living when buying options.  Those with exceptional technical analysis skills may also prosper.  But for the average individual trader, buying options as a primary strategy is a big mistake.

I am not suggesting these traders should be selling options.  Especially not naked options.  But there’s a world of option strategies between buying and selling naked options.

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More:

• Day Seven in this series of options trading mistakes. Under and over valued options.
• The series so far, ten biggest mistakes in option trading.

I invited Mark to contribute to this series and was delighted that he accepted, especially when he has his own very busy publishing schedule. Mark along with four other excellent bloggers are about to launch Expiring Monthly a journal for option traders. There is currently a a charter member offer for $79 (regular price $99) and you could even win a free subscription. I plan on subscribing.

Related posts:

1. Day Two: Ten of the Biggest Mistakes in Option Trading
2. Day Nine: Ten of the Biggest Mistakes in Option Trading
3. Day Seven: Ten of the Biggest Mistakes in Option Trading
4. Day Three: Ten of the Biggest Mistakes in Option Trading
5. Day One: Ten of the Biggest Mistakes in Option Trading
6. Day Four: Ten of the Biggest Mistakes in Option Trading