November 8, 2017

Advantages and Disadvantages of Buying Options

Hello, this is Dale, today's lesson is entitled, "Which is Better: To be a Buyer or Seller of Options?" Both have advantages and disadvantages. What I want to do in this webinar is go over the advantages and disadvantages of both and let you decide what makes sense for you.

The Option Buyer

If you're a buyer of options the advantage is you have unlimited potential gain. And you’re limited in your loss because you can't loss any more than the option premium price that you paid. If Apple goes in the direction you think it is, by the amount you think it will move, within the certain time you may have unlimited potential gains. That is the advantage. On the other hand let's say you buy an option. The price on that option might be 5 dollars.  Five dollars times a hundred shares per contract equals five hundred dollars.  That is the maximum you can lose.

Reference:  What factors go into an options price?


First Disadvantage of Buying Options

The first disadvantage is you have to pick the right direction. Is the stock going to go up or down?  Not only do you have to be right on the direction, you have to be right on the distance or the magnitude of the move. Finally if you have those two correct you have to be correct on direction and magnitude before expiration. If that move does come to fruition after the option has expired it's worthless to you. Actually, picking the right direction is extremely difficult.  An analyst who does this full time and is paid handsomely for it might do nothing but study a certain company for years. They know the business inside and out. They can still pick the wrong direction for a company's stock price.


Second Disadvantage of Buying Options

The second disadvantage is the option buyer also has to pick the right distance, or magnitude, of the move. If he buys an option believing that Apple stock is going to $220/share — and it's sitting at $200/share, what he's buying is something that is out- of-the money. That option has premium associated with it based on the time only. Apple not only has to go in the upward direction, it has to rise at least 20 dollars per share to get to the point where it's at $220/share.  If it goes to $210/share  this would be an example of getting the direction right but the distance wrong. Now, additionally not only does the price of the stock have to reach $220/share but the buyer also has to include the price of the option. Let’s assume about five dollars as the premium on that option. Not only does it have to go to $220/share, but it has to go to $225/share for you to break even. Then for you to make money it has to go beyond that. You have to be correct on the direction and you have to be correct on the magnitude.


Third Disadvantage of Buying Options

Finally, if you get those two right you have to have the move occur before the option expires.  Let’s say you go out about a month or two and put on a trade. If the move only comes to fruition 4 months down the road, you’re going to lose everything. The greatest difficulty the option buyer has to contend with is time. If your option contract expires before the underlying price moves in your chosen direction with the appropriate magnitude, the contract is worthless. So you're constantly battling time, referred to as theta decay, instead of having it work for you which I'll get into at the end of this article.


Theta Decay Example:

Say you have an option out around 90 days before expiration. For a while there's not going to be a lot of theta decay. In the last 30 days that theta decay becomes exponential. What that means is if you've bought an option that had a premium of $5, and if the stock hasn’t increased in price, the last 30 days that $5 evaporates quickly. You can see that buying has the advantage of limited risk but unlimited profit. That's the "lottery mindset that is so alluring about buying options. Yes, you can make money if it quickly moves in the direction you're looking for. If it slowly moves in that direction and slowly gets to the magnitude you need but takes too long you're going to lose.

Option Buyers: Probability of Success

Let's look at the odds against the buyer being correct. Attribute 50/50 odds to correctly choosing each of these three elements. If you took a coin and flipped it and said "Heads I'm going to buy a call, which is a bullish play, and tails I'm going to buy a put, which is a bearish play," you have roughly about 50/50 chance of being correct. Picking the magnitude of that move is even harder than 50/50.


Coin flip example:

I'm going to give the benefit of the doubt and stick with 50%. Is the move going to happen before expiration? I'm going to give that 50/50 odds too, which I think is generous for both the distance and the time. Mathematically if I take 50 percent times 50 percent times 50 percent, I get 12.5 percent. At best the odds of holding a profitable trade on an option to expiration are about one in eight. You may think you have an edge, but study after study shows you really don't. Let me just go back and say that if you are a buyer and you do choose the direction correctly and it happens quickly you may profit handsomely. Other than that the odds are against you that buying options will reward you in the long-term.


Advantages and Disadvantages of Selling Options

Reference:  a Naked Put or Naked Call is when a trader sells a position to open without protection.

Let’s look at the seller. The pure seller also (known as selling naked) has advantages and disadvantages too. The advantage is that the trader is collecting premium the entire time the position is open until is expires (hopefully worthless because that means the trade collected the entire premium). The disadvantages is that if you sell an option (naked) then you could sustain serious losses if the trade goes against you.


Credit Spreads - Most Effective Way to Trade Options

Reference:  Two popular credit spreads are the Bear Call Spread and the Bull Put Spread

Enter credit spreads. A credit spread is simply selling an option at a certain strike price and then buying one further out of the money for protection. A spread is the simultaneous opening of two or more option positions that offset one another. The set up is short selling calls or puts and simultaneously buying a call or put further out of the money. The most important attribute of any spread is that it can reduce the risk. If you trade a spread you can mitigate some of the risk that you have involved with an offsetting long position. If you go one step further and say I'm never going to let the spread  go all the way to expiration, technically if it moves against me I'm going to get out, you can mitigate your risk even more.

I hope you enjoyed this webinar on whether it's better to buy or sell. I think you guessed it. The next webinar is going to be on demystifying credit spreads either bull puts or bear calls. Hope you enjoyed this post and there's plenty more to come, right a comment or become a free member to find out more about how I build wealth trading options.