Be the Pit Boss of Your Own Options Casino
by Karim Rahemtulla, Investment U's Options Expert
Tuesday, September 21, 2010: Issue #1349
As an investor, there are always going to be times when you have regrets. It's the nature of the game.
For example, I've lost count of the number of times that I've heard things like, "If only I'd caught the market's latest rally." Or, "I wish I'd shorted that stock."
The problem is that until recently, the markets haven't really offered a great array of choices for investors to play their theories.
Take the options market, for instance. A few years ago, if you wanted to trade options, the only ones available were on large-cap stocks. Moreover, they usually had expiration cycles of no less than three months and wide spreads of at least 10 cents.
And in some cases, you might as well have headed to Las Vegas and taken your chances on the roulette wheel. The odds were pretty much the same.
But times have changed. And it's opened up a world of opportunity...
Embracing Your Inner Gambler
Over the past five years, we've seen significant changes to the options market. Changes that include increased liquidity (the volume of options that trade at a particular strike price), smaller spreads and more expiration cycles.
- Many stocks have options available to trade in penny increments (we're talking companies like Citigroup, Microsoft and others.)
- As of just a couple of months ago, options expiration cycles on certain very liquid stocks are as little as three days.
And with such short-term expiration cycles, the powers-that-be in the options world are introducing more viable ways for investors who want to bet on a particular short-term event.
- A Quarterly Earnings Announcement
In the past, if you wanted to play the outcome of a company's earnings announcement, you'd have to buy an option with the closest expiration date to the earnings release. Trouble is, it may cost you an extra two or three weeks of time premium.
Today, however, as the markets adopt more sophisticated technology, you might be able to buy an option the day before a company announces earnings with expiration the day after earnings are released.
- A Takeover Bid
Let's say a company announces a buyout offer for a rival firm on Tuesday. Within hours, the options market can issue options that expire on the Friday of that week, maybe a week or more before normal options expiration.
Question is, though: Is this true market efficiency or is it feeding a bad habit?
A New Era in Short-Term Options
In my opinion, the less time premium you have to pay for the outcome of a short-term event, the more efficiently you're being allowed to allocate your capital.
Remember that even short-term options must use the Black Scholes Model to determine pricing. And since the new measures have made time less of a major component, if you do lose, you'll lose less. On the flip side, if you win, you'll increase your return percentage, since your original funds at risk will be less.
Now keep this in mind: I don't advocate trading short-term options unless you're buying them for a specific event. But it's easier to do so because the volume of options trading and the number of people trading them has increased substantially in the past decade.
In fact, options trading is the fastest-growing segment of investing today. And this growth and increased attention has ushered in a new era for options traders. We're now seeing more choices, lower commissions and we're even on the verge of seeing options that may expire daily.
You may think this is crazy and for day traders only. But remember... options trading isn't just about buying options, but also about selling options. So while more opportunities exist for "gamblers," the same is true for those who take the other side of the trade.