Day Four: Ten of the Biggest Mistakes in Option Trading

Only Buying Out of The Money (OTM) Options

Time for a quick recap. Don’t loose all your money. Maximise your winners and minimise your losers. If buying options you need speed, direction and distance. Make sure you buy enough time; always buying short term options is a sure way to loose your money.

Conceptually only buying OTM options is the same as mistake three, not buying enough time. Beginning options traders think that by paying less for their options they are protecting themselves from losing all their money. However, the complete opposite is true. Most things in life that are cheap are pretty worthless and the same goes for options. You simply must pay for quality. (Now you may be thinking, that as you’re not paying for this information it too must be worthless. The reality is you are paying! You are trading your valuable time for this information. I do hope it has some value to you.)

If you always buy OTM options then before you place your next trade consider selling an In The Money (ITM) option instead. If you analyse the options you’ll quickly see you are increasing your odds of success and you are paying less for the extrinsic or time value. In general if you sell options you should be looking to do the reverse and maximise the extrinsic value you receive, but as with all rules that is one I often break.

Let’s look at an example of using Intuitive Surgical (ISRG). A fine Fool analyst and option trader just alerted me that ISRG has broken it 200 day moving average for the first time since January 2007. As Jim said this sometimes signifies a change in trend and is worth investigating.

Checking the chart I see ISRG has broken the 200d MA, though the 50d MA is still above the 200 day. In conjunction with fundamental input I do find technical analysis assists in my option trading, but that is a story for another day. A quick look at the fundamental stats in conjunction with the chart, without detailed analysis and just to get a starting point I’ll say there is a possibility ISRG could fall to the 150-200 region where it put in the big white candle back in July 2007.

Now let’s look at some quotes. I’d want to give my thesis time to play out and as always ensure I didn’t bet the house on this one trade. Checking earnings.com I see earnings were on 19 July last year and are expected around 21-31 July this year. I’ve got no opinion on ISRG’s earnings, but before placing any trade I’d try to get some idea. Anyway (stick to the point Dean) I wouldn’t even consider June options with nine days to go as that is a complete lottery ticket. July may be worth a look at, but October is probably what I’d go for.

ISRG Closed $269.66, let’s call it $270 and use a target of $200.

Looking at the two extremes here I’d wager most options beginners would be more inclined to look at the $220 Puts rather than the $320. After all the $220 is only $14.50 instead of $66.50. They convince themselves they can buy more, risk less and make a bigger profit if a large move occurs. However, as the above table shows they are paying about the same in extrinsic value and require a considerably larger move to breakeven and at the initial target actually make less on the all important $ basis and less important % basis. For the lower strike to be more profitable on a percentage basis the stock would have to drop 29% to $192.

If you picture a bell curve you’ll soon realise that buying the lower strikes dramatically reduces your odds of success and paying for ITM options has a higher probability of success.

I’ve used Puts in this example, but exactly the same principles apply with buying calls. If you want to play around with the spreadsheet, fell free to grab a copy of the option spreadsheet.

Next time you are going to buy an OTM option stop and think if an ITM option would be the better trade.