You Need Speed and Direction

Not understanding that option trades require both speed and direction to be profitable is often quoted as the number one reason why option traders loose money, it make it in to my list at number two.

Option trading is not stock trading. You can’t buy and wait, you can’t wait for the weighing machine to deliver your profits. You absolutely need the early exit poles to show the vote is in your favour. To consistently make money buying options you need to determine the direction, speed and likely distance of your chosen vehicle.

On average stocks are range bound 70% of the time. If you’re buying options the deck is loaded against you. You start with a 30% chance of movement and that’s in either direction, so you might have as low as 15% chance the stock will move in your direction. Factor in how far it has to move for your position to be profitable and you can see why so many option buyers consistently loose money. Short term option trading is difficult as you must correctly call the direction, target and speed of the underlying stock. On top of which time decay and volatility premiums are working against you.

you must correctly call the direction, target and speed of the underlying stock.

It’s difficult to win a game when you’re losing most of the time. Worse yet is many new option traders attempt to limit their loses by buying cheap options. Buying cheap out of the money (OTM) options doesn’t limit your loses, it guarantees them.

How to Overcome for Not Knowing the Need for Speed, Direction and Distance

The easiest fix is to become an option writer. Selling options lets you reap the rewards from market participants who don’t understand the need for speed and direction. When you sell options time decay and volatility premiums become you allies.

If you know yourself and buying options is the right path for you then ensure you consider the following:

1. Figure out your breakeven point before entering a trade. The breakeven point for calls is the option price + strike and for puts it’s strike – option. Determine if, in the time to expiration, the underlying stock or index is likely to move beyond your breakeven point.
2. Stop buying cheap options. Pony up for worthwhile options. Try buying either in the money (ITM) options or long dated options or LEAPS. While they may seem more expensive when you look at them from a breakeven or time value perspective you’ll see they are a lot better value than short term OTM options. If you’re not comfortable investing more, then adjust the number of contracts you buy while investing the same dollar amount as you would on those cheap options.

The following spreadsheet uses June Fedex Puts and Calls to illustrate how buying ITM options is normally the better choice. Despite being more expensive the ITM options are profitable sooner and require much smaller moves to become profitable. Comparing strikes like this is a quick way of determining the best strike to buy. This spreadsheet shows how it would require an 8% move up before the OTM Call became more profitable an a -7% move for the OTM Put to become more profitable.
You can enter your own figures in the white cells.