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Know Your Options

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With the market going up, and people getting more bullish, there will be an increasingly larger number of people buying call options on those stocks they expect to go up even further.

However, there will also be an increasingly larger number of people losing money on those very same call options designed to make money as the market rises.

It's sad, but true.

There's nothing worse than buying an option (call or put), and seeing the market ultimately move in the direction you expected, but still losing money on your option nonetheless.

This is usually the result of some all too often made mistakes.

The good news is that these mistakes can easily be corrected.

I'll outline three key mistakes that options traders make, and then provide a solution for each one them.


Problem #1) Unrealistic Expectations and Low Probability Options

I was going to name this first point 'greed'. But it's really just human nature.

After losing money in your stocks over the last few weeks, one might be tempted to swing for the fences and load up on puts in an effort to try and 'make it all back' in one fell swoop.

They'll go out and buy a bunch of cheap options (so they can buy more of them), but with deltas so pitifully low that they'd need to see a gigantic move for those to ever payoff.

Solution: Focus in on the options with a delta of at least 60%, and preferably 70% or higher.

The delta tells you how much your option should move in relation to the underlying stock.

But the delta is also considered to be a gauge as to what percentage likelihood there is of the stock reaching that option's strike price by expiration.

An option with a delta of 75% means there's a high likelihood (a 75% likelihood) that that option will expire in-the-money.

A delta of 20% means there's only a 20% likelihood of that option finishing in-the-money. And do you really want to load up on a bet with only a 20% chance of success? I don't.


Problem #2) Not Buying Enough Time

Whether you're expecting a stock to go up or down, we have a tendency to overestimate the size of the move that could be seen, and underestimate the amount of time it could take to do it.

With an option, if you run out of time, it's game over. And with many investors skimping on how much time they buy in their options, this happens all too often.

Solution: However much time you think it'll take for your stock to do whatever you think it's going to do, add at least one more month to it and buy the option with at least that much more time.

Plus, the options with more time are almost always the better value. An option selling for $500 with 2 months of time may seem cheaper than a $700 option with 4 months of time, but it's not the better value.

For example: $500 divided by 2 months means you're paying $250 for each month of time that you purchased.

But $700 divided by 4 months means you're paying only $175 for each month of time. That is the better bargain. And more often than not, you'll be glad you had that extra time as that can make the difference between making money on your trade or losing it all.


Problem #3: Trading Options Like Stocks

I'm all for cutting losses and letting your profits run. But with stocks, your time to let your profits run is unlimited. What I mean is, if the stock makes a good move and you're expecting more to come, you can wait a stock out if it starts to consolidate, or makes a possible retracement, etc. But, ultimately, if the stock eventually continues its move in your direction, all is good and the gains will add up.

But options are different since there's limited staying power.

Solution: Regardless of your outlook on the stock, even if it's moving for you, consider getting out of any option once it has only 30 days of time left.

Options, even those that are in-the-money, are comprised of both intrinsic value and time value. And if your options are out-of-the-money, they are comprised of only time value. Time value, of course, is a fleeting asset that's prone to time decay.

And within 30 days to expiration, that time decay accelerates tremendously, meaning your option would need to appreciate in value by a certain amount each day just to stay even.

So if your stock is in a consolidation period (or worse, is pulling back) then your option is losing value. Even if the stock was standing still, your option is still losing value each day that ticks away.

There's even a way to see how much your options could potentially be losing per day just due to time decay. That metric is one of the 'greeks' and it's called Theta. And it will show you how much premium your option will lose in time value each day.

So options, as they get closer to expiration, lose their staying power, unlike stocks where the staying power is constant.

So set yourself a rule that you'll jettison your options before you get into that 30-day time-decay red zone and roll into a new option.

But don't be afraid to pull a profit and seek out the next opportunity that looks as promising as the one you just profited from.

As the saying goes, you'll never go broke pulling a profit.

Follow these three tips to overcome common mistakes in your options trading and you'll start making money no matter what the market is doing.

You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

And be sure to check out our Zacks Options Trader.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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