Double Your Money

The Smart Profits Report: Issue #135
Monday, August 16, 2004

Double Your Money: The Truth About Making 300% Overnight in Options
By Mt. Vernon Research Team

The people who ask me about getting into options always want to know the truth about doubling their money overnight.

And why not? I can’t blame anyone for wanting to know the secret to making 50% in two days or 148% in three weeks - with an occasional 300% winner - over and over again.

But the truth may not be quite as alluring as the promise. Before you set out to be the next options king, let’s take a dose of reality medicine.

Starting with this: If you’ve bought any “introduction to options” books, throw them away. Don’t let them infect you. Or at least lock them up until next year when you know enough from experience to glean the scant wisdom in the back pages, because the front pages are full of lies, starting with the examples of how much money you can “easily” make.

Options Truths: What Every Book Says Is Dead Wrong

The big lie goes like this: If you buy an $80 call on IBM for $3 and IBM goes up to $85, you are going to make big money. Instead of making a mere 6% by owning IBM stock, your IBM option will go up to $5 or more, a grand 66% return on your $2 investment.

This will usually be accompanied by some mysterious risk profile graph to prove the point.

So there you are, you just read the example and it makes sense. All it takes to make this money is a $5 move in IBM. Why, that’s entirely reasonable, you think. IBM moves $5 all the time. And wham! You’re suckered right in. You’ve opened an account and you’re ready for the world of short-term options trading.

How to Lose Money on Being Right With Options

What actually happens isn’t at all like that example. To get those results, you’d have to hit your target about two minutes after you bought an out-of-the-money option, which is a very risky buy. And even then, IBM would really have to move up to $85.75 to cover the spread and commissions.

Here’s what happens to most unsuspecting traders: While you are waiting for IBM stock to reach $85, your $3 option wastes away to $2, then $1.50, then $0.50, then nothing. Even if you get out sooner with a stop loss - pay attention here - you still have a loss. All you did was stop it from getting worse.

Meanwhile, IBM only climbs to $82.75 and you wish you’d just bought the stock. And in case you aren’t sufficiently humbled and broke yet, the week after your option expires, IBM will shoot up to $86.

But then you’re really hooked. You were right, after all! You would have made huge money if it had happened just a bit sooner. If you’d just taken an August contract instead of a July contract… We’ll get ‘em next time, you think…

If you are trading option contracts with less than four months to expiration, it’s not the direction you’re driving that will kill you… it’s the speed… or rather the lack of speed in the price-action of your chosen stock.

To Heck With Good Stocks - You Want Fast Stocks

To make money speculating in options you have to do better than choosing the right direction and strike price. You also have to buy your option exactly when the stock is moving in decisive bursts. If it doesn’t happen quickly after you execute your trade, the value of your option will drop so fast that you’ll lose money even if your stock is headed the right way.

Contrary to all those examples in the get-rich-quick books, you can hit your target and still lose money with short-term options. It’s not a straight-line depreciation, either. The shorter the contract, the faster time value disappears on options.

Let me explain…

Time Value On Your Options Contracts

If a stock sits still for three weeks, you lose about 25% or so of the value on an option that has three months to run, but you’d lose about 70% of the value on an option with only a month to run.

That’s why, even as a short-term trader, I rarely take an option with just one month to go. The flip side is that if the stock moves nicely, you’d make a much bigger return (at very high risk) on your one-month option compared to the three-month option.

To make winning even harder in this exciting world of short-term trading, while your stock is ambling around, trading in a range, chances are it’s entered a quiet period and its volatility is dropping, too. That will take another chunk out of the price of the option since high-volatility options are worth more than low-volatility options.

That’s the big secret to doubling your money with short-term trading that the books leave out: With options, you might win big on a stock that only moves up a buck, and you might lose on one that moves up $5. It depends on how fast the stock moves… plus whether you choose the best contract, the right strike price, give yourself the right amount of time, and whether volatility changes.

Good Trading,

Mt. Vernon Research

Today’s Smart Profits Cribsheet

Check out our Smart Profits Glossary for more on terms like “strike price,” “volatility” and “LEAPS.”
Looking for more information on Time Value? Check out Smart Profits #110, Time Value: With Options You Need to Be Right on Time.

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