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Option Losses
The Smart Profits Report: Issue #198
Thursday, April 7, 2005
Option Losses: How to Grow Rich From Your Options Losses
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Now, I know that most newsletter editors will not admit to mistakes. It makes for terrible marketing copy.
But guess what… I think that having option losses and admitting to them has an important educational and therapeutic effect.
- First, analyzing losses helps me to better understand the statistical relationships between LEAPS and the underlying shares in various scenarios.
- Second, acknowledging a loss humbles me before the market gods. It’s good to be humbled every so often - because nobody is more set up for catastrophic losses than an arrogant trader.
The Markets Educated Me…
Some fellow investors and I entered into a two-year LEAPS play. We bought the LEAPS for $2.65. The underlying shares were trading for $27. So for 1,000 shares we could have spent $27,000 - or to control the same 1,000 shares for TWO YEARS, we could pay $2,650.
Because I am convinced that no one holds shares for more than a few months these days - let alone two years - I chose the LEAPS option (forgive the pun).
Stay Humble Before the Market Gods
Well, three days into the trade, the shares moved up 7%. Our LEAPS were up 30%. I should have sold! I have learned this lesson before. I should have pulled the trigger.
With a one-year LEAP I would have pulled the trigger. But with TWO YEARS left, I felt a little greed would be allowable. Bad call…
On the fourth day of the trade, the company came out with bad news. The news was unexpected and unpredictable. The shares plunged at the open, falling to $24 from $28.70. That is close to 20%.
The news was bad enough that it changed my outlook on the future of the company. Sometimes bad news can have a short-term effect and we don’t sell. I mean, we usually have two YEARS left on our long-term options. We should not react to news that may not have long-term impact.
This case was different. I issued a sell. Since all of my buy and sell prices come from ACTUAL customer trades (sent to me by our recommended broker based on trades made by dozens of REAL customers), I was happy to learn that his customers were able to exit the position at $2.25 on average.
How It Could Have Been Much Worse…
This means our losses were limited to 40 cents - I am sure some of my readers did better and some did worse.
But if you look at the numbers, we lost 40 cents on this trade compared to more than $3 for the investor who bought the shares at the same time. In fact, the MOST we could have lost was less than the actual amount lost by stock-only investors.
As I try to explain to my readers and attendees at seminars, LEAPS offer you not only superior upside potential compared to shares, they also offer you SUPERIOR downside real-dollar-loss protection.
So, while I NEVER like to lose money (fortunately, we made $2.40 per share the week before on another trade, more than making up for our small loss here), it is important that you realize that using LEAPS is not just a speculative options strategy. It makes sense much more often than not.
And even when LEAPS go south on us, we’re still in position to lose less than common stock traders.
Great trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of words like “LEAPS” or “long position” found in today’s article.
Related Articles:
- LEAPS Option Strategies: A Gold Strategy That Beats Stocks, Bullion or Coins
- Derivatives: Take the Big Guys’ Money With Their Own Weapons
- Trailing Stops: How to Give Your Options Room to Grow
