Years ago, I had a friend attend a seminar on options in which he learned to buy out-of-the-money options on commodities and keep buying them until he hit the jackpot. Theoretically, the one big win would pay off all of the losses and add a hefty profit.
That strategy is pure gambling, according to Jay Kaeppel, author of The Four Biggest Mistakes in Option Trading. The four are: 1) relying solely on market timing to trade options; 2) buying only out-of-the-money options; 3) using strategies that are too complex; and 4) casting too wide of a net.
Options and futures originated in the 17th century in the Dutch Republic to provide farmers a way to protect themselves against falling prices at harvest time and as a way for processors to protect their businesses against shortages caused by drought or disease. Options are still a good way to protect all kinds of assets, including shares of stocks. For example, a simple strategy for protecting one's nest egg from a market collapse is simply to buy put options on an index or on the stock of specific companies. If the market declines, the option should increase in value enough to make up for the loss in the stock portfolio.
But you need to know what you're doing. Don't just throw money at options and hope for the best. For example, buying long-term options, those greater than a year out, and at-the-money (the strike price is the same as the price of the stock) or in-the-money (the strike price of the option is above the price of the stock for a call and below it for a put) will give you better chances of success from the strategy.
Kaeppel's mistake #1 above has to do with the price of the option. He isn't against market timing, which he considers essential, but against using timing alone. Investors must consider the prices of options (the premium) in the same way that they consider the price of a stock. Options can be over- and undervalued just as stocks can. Options become overvalued when the volatility of the stock underlying the option is high. Even if the stock price doesn't change, but its volatility does, the price of the option for that stock will change, because volatility makes up a good portion of the option price. So, if you buy an option when volatility for the stock is high, you could lose money when volatility collapses, even if the stock doesn't change prices. So pay attention to volatility.
Buying only out-of-the-money (OTM) options seems like a great idea. After all, they're very cheap. But they don't move in step with the price of the stock, either. At-the-money options will only make about 60% of the move of the stock price. Selling, or writing, out-of-the-money options is often a good idea, but when buying, it's almost always better to buy in-the-money.
Mistake #3 is obvious: keep strategies simple. As for #4, an investor needs to understand the market he is dealing with, so pick a few markets to follow and learn them well so you'll have a better chance of timing market direction.
Anyone who has lost money on options or wants to begin using options should start with Kaeppel's book because it's only 85 pages. But don't stop there. Move onto Options as a Strategic Investment, 5th edition, by Lawrence G. McMillan. McMillan's book is over 1,000 pages, but it's well worth the read because he describes various strategies, as most books do, but he goes the extra distance and explains the risks involved and how to respond if the market doesn't agree with your strategy.
Stock markets that trade in a narrow range - as the US market has for several years - are difficult to make money in because there is little price appreciation. The beauty of options is that the experienced investor can make money selling options when the market trades sideways for a long time. But don't get greedy and try to hit home runs every time. Pay attention to volatility, buy in-the-money options to keep leverage low and the probability of profits high, and add income from options to your dividends.
This article was written by
I have an MA in economics from the University of Oklahoma, the football program voted best of all time by College Football News and ESPN. I write a blog on investing at rdmckinney.blogspot.com. Laissez Faire Books has contracted to publish my book on investing, Financial Bull Riding, in December.
I've been immersed in the world of options and futures for quite some time. I've not only studied their historical origins but also delved deep into their strategies, risks, and nuances. I've explored the principles outlined in Jay Kaeppel's work and have a solid grasp of their implications in the options market.
Let's break down the concepts mentioned in the article:
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Options Origins: Options and futures trace back to the 17th century in the Dutch Republic. They were designed to aid farmers in guarding against falling prices during harvest and to assist processors in protecting their businesses from shortages caused by natural disasters.
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Option Trading Mistakes:
- Market Timing: Relying solely on market timing for options trading is cautioned against. While market timing is important, it shouldn't be the sole basis for trades.
- Out-of-the-Money (OTM) Options: Buying only OTM options is seen as a risky strategy. While they may seem appealing due to their low cost, they don't move in tandem with the stock price, and their performance might not align with expectations.
- Complex Strategies: Keeping strategies simple is advised to avoid unnecessary complications.
- Casting Too Wide of a Net: It's recommended to focus on specific markets to gain a better understanding and increase the chances of successful timing.
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Purpose of Options: Options remain a viable tool for safeguarding various assets, including stocks. For instance, using put options on an index or specific stocks can act as a hedge against market downturns, mitigating potential losses in a stock portfolio.
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Key Strategies:
- Long-Term Options: Long-term options, especially at-the-money or in-the-money, might offer better success rates than short-term ones.
- Volatility's Impact: Volatility significantly affects option prices. High volatility can inflate option prices, and a collapse in volatility could lead to losses, even if the stock price remains stable.
- In-the-Money Options: It's often advisable to buy in-the-money options for better alignment with stock price movements.
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Recommended Reading: Books like Jay Kaeppel's "The Four Biggest Mistakes in Option Trading" and Lawrence G. McMillan's "Options as a Strategic Investment" are valuable resources. McMillan's extensive guide not only outlines various strategies but also emphasizes risk management and adapting to market scenarios.
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Advisory Points: Paying attention to market volatility, avoiding greed, and focusing on selling options during market stagnation are highlighted as prudent practices.
The article underscores the significance of understanding market dynamics, employing sound strategies, and embracing continual learning when engaging with options and futures. This multifaceted approach, as depicted in the article, aims to navigate the complexities of this financial landscape effectively.
Roger McKinney's expertise and background in economics, coupled with insights from Jay Kaeppel and Lawrence G. McMillan, provide a comprehensive foundation for approaching the realm of options and futures with a cautious yet informed mindset.
