Why (and maybe, why not) to consider OPTIONS TRADING as a tool in your arsenal
[Updated version of my original 1999 DAYTRADING FUNDAMENTALS post on this topic]
A thorough coverage of OPTIONS TRADING deserves at least a few thick books. However, I'd like to share our perspective through a few observations about it that are pertinent to our stock-trading thread discussions and operations. As background, I have invested a tremendous amount of time in the past trading both index & individual stock options. I continue to trade index and stock options today, although more selectively and with a smaller portion of my capital. Although I've made some great returns trading option positions, I arrived at the conclusion years ago after much experience and thought, that in most situations stocks are generally a superior mainstream trading vehicle, for the following reasons.
Options become very alluring to many aspiring stock traders because the leverage is so much greater. I would state flatly, unequivocally that it is certainly possible to make a lot more money trading options, than trading stocks. HOWEVER, it is also possible (read: likely) to LOSE a lot more money trading options than trading stocks! And that is what usually happens. The reason is, with options there are several more things working against you. First of all, you have to pay the (often wide) spread, which can be a substantial portion of the contract price (more than with a stock, generally). Second, you have "the Greeks" to deal with, particularly Delta, which means the options will not "track" the underlying stock 1:1, or even 0.5:1 when it moves - often a big disappointment. Then, you have the implied volatility factor which is built into the pricing model - the option can be "pumped up" when there is excitement in the underlying issue, and "deflated" at any time without changes occurring in the underlying or the passage of time being a requirement (these changes are different than time decay; when short-term trading options the much-noted time decay factor is often less important than you might think).
The implied volatility changes occur in a way that makes it harder to "jump" an option in a stock or index that is already moving - inevitably, by the time you want them through TA/momentum etc, they are already "pumped up". Finally (although this can be mitigated by traded spreads, naked options, etc) you have to work against the "time decay" (a separate factor than implied volatility), which is steadily decaying the option price the longer you hold it.
Because of the way options move, it can be much more difficult (psychologically) to implement a good stop-loss strategy. For many option traders, the stop loss is provided by controlling the size of the position, with each position being subject to a total loss if it goes against them. It IS possible to use stops with options (there are a variety of methods that work - direct stop, contingent stops), but it is much more difficult to implement than with stocks.
When thinking about option prices, to avoid becoming confused it's important to fully understand that an option price is composed of two components: the intrinsic value, and the time value (also known sometimes fondly as, "the juice"). The intrinsic value is related to how far the option is "in the money" (beyond the strike price), and the "time value" is related to how much value the market places on that option between the current time, and expiration. Most of the fancy math, Greeks, etc. relates to how the time value component is valued. It becomes simpler/clearer once you sort the pricing model out.
There are many complex options strategies (we teach a few of them) which can be wonderful risk/reward control tools for certain scenarios - spreads, straddles, butterflies, etc. The pro's who trade these complex options with all the associated commissions/transaction costs generally do so with lower commissions where these complex trades make more sense (most option pros trade volatility, not price direction). Spreads are a conservative way to trade options which we frequently employ as a means of playing a longer-term "position-trade" moves without tying up much capital. Writing naked options (with stops!) can also be a great way to go, provided you know how to control risk (e.g. our recent KKD, NVDA, and BKX short call trades). But they (naked index options in particular) come with steep margin requirements at many brokerages because of the perceived risk - essential, you are writing the option to the buyer. Covered calls (done correctly, which isn't as easy as it looks) can be an effective profit-booster for the longer-term position trader or investor but are generally not appropriate for the shorter-term trading style we employ.
There are also many complex options strategies - strangles, straddles, butterflies, etc. which we employ that can be great for certain market scenarios that set us up for substantial gains while also taking out much of the risk. That is really what options are about - they give you a greater degree of control in designing positions that limit risk, when used properly. But, most traders never get there!
If you are going to trade options, I feel the most lucrative way to trade them is daytrading them (including overnight swing trades). It is a whole different game/methodology than daytrading stocks though, and it helps to be very good at daytrading stocks first, then to use only a limited (say, 5%) portion of you risk capital to trade options. Even then, you must keep careful tabs on the equity curve of your options trading.
That being said, if I were put into a prison cell, allocated some capital and told that I couldn't be released until I'd made $X, I would immediately setup for real-time options trading (... could you get me a Pentium III with OptionVue 5?<g>). That being said, don't be easily persuaded to try options early in your trading career, simply because the risks are much higher than stock daytrading - there is so much more leverage and attendant risk.
The problem thing is, you have to survive the learning curve period, which can be lengthy. I spent years using OptionPro, OptionStation, OptionVue, etc. reading books/taking seminars learning how all of the Greeks work, how options are priced, etc. before I really got a good handle on, and became comfortable with, option pricing. Don't be put off by the apparent complexity of the Black-Sholes options pricing model... it is really simple when you boil it down. Until you reach that point, you are working at a severe disadvantage. One of the big things about options is... surviving the learning curve!
With options, the STARTING point for a successful trade is to be right on timing and direction. That does not even come close to assuring a successful trade. With stocks, it is easier to complete a successful trade. So, the odds for success/longevity are much better trading stocks. One common danger with options is, you can make so much money so quickly trading them, that you may become too aggressive and set yourself up for serious damage. If you refer back in the thread to my post "The Loser's Spiral - the dark side of trading" this happens to A LOT of options traders. At the brokerages, often the option-broker rooms are referred to as "the Gambling pits". There is a reason for that!
However, it is possible to trade options in a disciplined fashion, with stops, etc. and to control your position size so that the inevitable "wipe outs" (lost of most or all funds invested in your trades) is tolerable. X dollars into their trades, zero dollars at end of trade. Doesn't happen so easily with stocks! Anyway the point is, ESPECIALLY for beginning to intermediate traders, you are much better off with trading stocks. Stock traders having the normal difficulties are often lured into options, seeing them as an "easier" way to make a profit.
I'd recommend getting very good at stock trading first, then if you want to extend your trading/timing skills into options, do it with a small % of your trading capital, until you've proven to yourself that it's a sustainable profit center.
That is why we use options very selectively and strategically in our trading. If you're interested in them, we'll be offering a free mini-seminar on the topic later this summer. In the meantime, we recommend taking it easy & playing it light with the options trading while keeping your main focus on becoming an excellent stock trader!
Good trading, Steve |
