by Dr. Mark Skousen, Chairman, Investment U
Monday, July 10, 2006: Issue #556
Option trading isn’t for everyone, but then again, neither is bungee jumping. But it’s a heck of a ride.
In my short-term trading services, I recommend out-of-the-money call and put options for aggressive speculators willing to take a flyer. Option trading is gambling – let there be no doubt about this – and you can lose your shirt.
Yet, despite these caveats, I’m always amazed at how many of my subscribers to these trading services play the options market. Investors are trading options like never before as part of their portfolio strategy, and volume on all of the option exchanges is skyrocketing. (See the table below for total volume of equity option contracts.)
Year Volume (Contracts):
- 2005 1,369,048,282
- 2004 1,083,649,226
- 2003 830,308,227
- 2002 709,784,014
- 2001 722,680,249
- 2000 672,871,757
And so far this year, total volume is up to 916,489,507 with nearly six months left to trade!
Over the years, the media, financial planners and brokerage firms have warned the investing public to stay away from the options market, except perhaps writing covered call options as a way to protect a portfolio of blue chip stocks. As a disclaimer, the pundits of conventional wisdom exclaim with trepidation, “Eighty percent or more of option buyers lose money!”
Perhaps. But those are better odds than playing the lottery, or placing a bet on #7 on the roulette wheel. Moreover, if you have carefully selected a stock or commodity that looks fundamentally and technically in your favor, you may possibly increase your odds of winning big by buying call options.
The Options Strategy Starts with Understanding Risk vs. Reward
For the aggressive speculator, the lure of option trading is enticing. If one of my stock recommendations runs up 30% in a month, imagine how well your call options will do. You could earn 200%, 500% or more in a short period of time. In one of my recent recommendations, a stock rose 30% and the out-of-the-money call skyrocketed 2,500%.
In the past two years, I’ve noticed a pattern in my trading services. We’ve made money on our stock recommendations, but we’ve made a fortune on our stock options. For example, in the Skousen High Income Alert service, our average recommendation has gone up 28% in the past two years, but our options have averaged an 89% return.
What if you are wrong? You can lose 100% of your money. But that’s the limit of your downside, and why options are so popular. Your losses on buying call or put options are limited to your investment. (Note: No such limits exist, however, when you sell options or futures contracts.) As an aggressive speculator, I regard the risk-reward relationship as sufficiently favorable to play the options game, but you may feel differently.
With its growing popularity on Wall Street, the major exchanges have been accommodating by offering option contracts on thousands of publicly-traded companies and stock indexes, including many foreign ones. I’ve known quite a few aggressive speculators who have made fortunes trading options. But not every investor has the stomach for this fast-paced high-risk gamble.
Based on my experience with options, here are five points to remember when buying call options:
Five Principles for Trading Options
- 1. Time works against you. Options are strictly a short-term strategy. In order to make money in options, you have to be right about both the direction of the stock and your timing. An option is a wasting asset. For long-term value investors, time works in your favor, but in options, time works against you. You might be absolutely right that Apple Computer (Nasdaq: AAPL) has to go up in the long run, but an option is a short-run speculation. Option contracts may extend outward to nine months, sometimes a year. You can also buy long-term options called “LEAPS” – Long-term Equity Anticipation Securities. However, the farther out you go, the higher the premium you pay. There’s no free lunch. You can pay a lower premium by buying a call option further “out of the money.”
- 2. The underlying stock must not only rise in price, but it must rise significantly for you to make money. In the above case, suppose you buy a January $65 call option on Apple. This is an “out-of-the-money” call, because Apple is currently selling for around $55 a share. You would have to pay $400 – plus commissions – for the privilege of buying this Apple call. Now suppose Apple rises to the strike price of $65 by January. Your option will expire worthless, and you’ll be out $400! In other words, the price of Apple needs to rise an additional $4, to $69 by January in order for you to break even and get your $400 back.
- 3. Focus on volatile stocks. Stable, conservative companies may enjoy low premiums on their options, but they are not likely to advance much in price, either. In dull markets, buying calls can be a slow way to financial ruin. Volatile growth stocks or commodity stocks give you the best leverage. Apple Computer is a good stock to buy options on, because it’s a volatile tech stock.
- 4. Limit your trading to stock options with good liquidity. Check the volume and open interest before you buy a call or put option. Illiquid options with low volume tend to suffer from high bid-ask spreads. It doesn’t take much for these options to move up or down, and you could get caught holding the bag.
- 5. Play only with money you can afford to lose. This is easier said than done. But as Ben Franklin says, “Experience keeps a dear school, yet fools will learn in no other.”
P.S. In my next letter, I will discuss “Black-Scholes Made Easy.” If you trade options, or want to get educated, you won’t want to miss this “easy” way to profit from the Black-Scholes formula for pricing options.