Common Option Mistakes

The Smart Profits Report: Issue #273
Tuesday, January 10, 2006

Common Option Mistakes: Four Options Resolutions to Make Today
By Steve McDonald
Advisory Panelist, Mt. Vernon Research

It’s that time of year again. Time to take a look at our lives and change for the better. This year, let’s try to make some changes that will make us more money. Now that’s something we can really sink our teeth into.

Let’s look at four common options mistakes that can drag down account balances, and make 2006 the year we put them behind us for good…

Common Option Mistake #1: Don’t Buy Out-of-the-Money

When picking an option, the most tempting thing to do is to get it cheap. We tend to think we are getting a better deal that way, but 99% of the time, we’re not. Let’s use the Intel (Nasdaq: INTC) January calls as an example:

A few weeks ago, INTC stock was trading at $25.33. The $25 call was in the money and traded for $1.35. But the $30 call was only five cents! Seems too good to pass up… Why pay $1.35 for a call when you can get one a few more dollars out-of-the-money for a lot less?

Well, experience tells us that buying the $25 call is a much better bet. The option will move dollar-for-dollar with the underlying stock. So, if the INTC goes to $27, the call should go up $2, too. The out-of-the-money options almost never move until the stock has reached, or almost reached, the strike price. Chances are, you will end up with another loser.

As a novice, I bought many options out of the money, thinking I was getting a better buy. I was wrong 99% of the time. Buy out-of-the-money options and you have about a 1% chance of making money.

Common Option Mistake #2: Cut Your Losses Early

When an option starts to tank, it is most likely going to continue its losing ways. The same is true for winners. If a stock is moving up, the option normally follows, but it’s the losers we remember.

When I have a list of options I am following, I cut my losers early. They usually don’t come back - at least not for me. Maybe you have better luck than I do, but the “80/20 Rule” applies here for me.

The 80/20 Rule:

80% of options that have a significant drop in price.
25% or greater, don’t come back.

I would prefer to cut my losses early and give up the other 20% that might turn into winners, than chase the dogs to death.

Remember, only cars and options eventually are guaranteed to be worthless.

Common Option Mistake #3: Don’t Bet the Farm

There shouldn’t be too many questions about this one. This is the guaranteed red-face maker. The urge to jump in with both feet is just too great for most of us.

The typical scenario that leads to a big loss is to buy an option and have it move up a little. Let’s say we buy at $.25 and it’s at $.35 on the bid. That’s a 40% move. What we should do is take the money and run, but most of us just can’t take a profit. Most people will say to themselves, “It’s only been a few weeks and I have a lot of time left on this one; why not, let’s buy some more and make a killing.”

This is the “Moon Shot” method of investing. We know this one is going all the way. Next stop: retirement. We put more money into what has been, until now, a winning position. Our average cost goes up and our odds of wining go down.

Why should we avoid this? Because the traders who run this business know what you’re thinking before you think it. The hook has been set and you’re about to learn a very expensive lesson.

Watch a lot of options and how they move and you’ll see that they rarely go straight up. There are lots of dips along the way. These dips are where we usually get scared and jump out to cut our losses.

Not everyone will agree with me, but my 25 years of option trading tell me to cash out and not look back. Never put too much money into one option. Avoid the urge to buy as it moves up. There are lots of plays to come, don’t get piggish.

Common Option Mistake #4: Avoid Low Volume

Remember when your parents told you it’s not okay to do something just because everyone else is? They never traded options.

When I am picking an option, it has to have a lot of volume, preferably several thousand open positions. Every time I have ignored this rule, it has come back to bite me.

With a stock as popular as INTC, there is no problem with interest. Most options don’t have this kind of volume. You really have to be disciplined about this. No matter how good it looks, if you are one of the few people interested, there is probably a very good reason.

The other issue with volume is how recently investors have been buying the position. When you enter your buy in your portfolio, it should tell you when the last trade was placed. Too many times, I have picked an option and watched it do nothing for a couple of days, just to realize there hasn’t been any activity for a week. Not a pretty sight, and it always costs me money.

Volume is essential when picking a winner. If no one is buying it, you won’t make any money on it.

Good Luck in the New Year,

Steve

Today’s Smart Profits Cribsheet

There are more than four ways to improve your trades, of course. Check out some of my previous ideas on how to save money and protect your portfolio - Smart Profits #261, Option Prices: How to Get the Best Price on Your Options, and Smart Profits #268, Principal Protection: How to “Defend” Your Principal From a 50% “Bomb.”

And speaking of not betting the farm on your options trades, Karim has some great tips on position sizing here - Smart Profits #229, Option Position Sizing: How Much to Invest In Each Option Trade.

I mentioned today that when you buy out-of-the-money options, you win about 1% of the time… So, what does that say about your odds when you sell the same options? Find out how Lee Lowell, fellow Mt. Vernon Research member, uses this fact to his advantage… Smart Profits #270, Selling Covered Calls: Getting Cash for Stocks You Already Own… Without Giving Them Up.