by Ken Trester 09/29/08
You Need Enough Time to Be Right
In the options business, option buyers generally tend to violate two primary principles:
1) They don't give themselves enough time to be right, and
2) They mistake cheap options for inexpensive options.
I like to describe options as a wasting asset. They are not perpetual investment instruments. The closer you get to expiration, the faster the option price decays.
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For example, let's take two hypothetical call options, both at the same strike price, but with different expiration dates. Let's assume Option A expires on the third Friday in January (remember, options expire on the third Friday of the month); while Option B expires two months later on the third Friday in March.
Using 2008 as our example, Option A expires on Jan. 20 (remember, options expire on the third Friday of the month); Option B expires on March 17. Now let's suppose it's the first trading day of the year, Jan. 4, 2008. That means Option A has 16 days left until it expires and Option B has 57 days left until it expires. (Remember, 2008 was a leap year, so February had 29 days.)
In 16 days, Option A will either turn into stock or it will disappear. By that, I mean that the price of the stock will rise and we will exercise our call to obtain shares of stock at the strike price, or we will let the option expire without exercising it.
Time decay is intense in these options because of the truncated time frame.
Meanwhile, Option B has 57 more sunrises and sunsets for the underlying stock to move in its favor, so the odds significantly favor the investor who bought the option with more time.
Option buyers who find they are frequent losers rather than winners are often buyers of near-term options who have stacked the odds against themselves by buying an option with so little time for them to be right. In most situations, I recommend having 30 days or more to be right.
When you invest in the wrong options, you've really moved the odds against yourself. In fact, you'd be better off playing roulette in a casino, because at least the casino will buy the loser a drink!
There's Cheap and Then There's Inexpensive
Giving yourself time to be right starts with looking beyond an option's price to find the real value, because investing in the wrong options really means moving the odds against yourself.
Rather than buying an at-the-money $25 call (which means that the strike price of the option equals the market price of the underlying security) that is selling for $1.75, a novice might buy the out-of-the-money $30 call (i.e., the strike price of the call is higher than the price of the underlying asset) that is selling for 50 cents.
Sure, they could buy three of those $30 calls for the price of just one $25 call, but there's a reason for that apparent "cheapness" -- it's a long shot. The out-of-the-money $30 call looks cheap, but buying it means betting that the stock will trade outside an expected range of projected prices.
Don't get me wrong -- sometimes the outcomes are indeed outside the range predicted by price models that determine where a stock will be trading in the future, but you should understand that you are betting against the odds.
Sometimes you've got to avoid that "cheap" bet at all costs!
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If you want to trade like the pros, don't invest against the odds -- invest with the odds in your favor. Option buyers who find they are frequent losers rather than winners are often buyers of near-term options -- they stack the odds against themselves by buying an option that gives them too little time for them to be right about the stock's performance by expiration Friday.
To put this in gambling terms, when we invest properly with options, we are betting with the odds in our favor. And when we invest in the cheap options, we are betting against the house.
There's no need to be a math whiz or computer genius to invest with the best chance of winning -- you just need to avoid those sucker bets!
To lean more about Ken Trester, read his bio.
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