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Know Your Options

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Why do some people have more 'luck' when buying options than others?

Better yet, why do some people have better luck with stocks than with options?

I believe a lot of that has to do with fully understanding how options work.

Believe me, options are not rocket science. But there are a few more things to consider than when buying a stock.

For example: Delta. This is the percentage the option will increase or decrease in value in relation to the underlying price movement of the stock. The delta gets bigger as it gets closer to being in-the-money or goes further in-the-money. The delta gets smaller as the option gets further out-of-the-money.

For example: let's say you bought an out-of-the-money option on stock XYZ for $500 with 2 months of time until expiration. Let's also say the option had a delta of .5, which means it'll move 50% of the underlying stock's movement, or in other words, it'll move 50 cents for every $1 the stock moves.

Now let's say the stock goes down -$3. That option will likely decrease by -$1.50. (50% of the $3 move.)

However, that option's delta will also now have fallen. Let's say that option now has a delta of .40.

If that stock went back up $3, that option will now only have increased by $1.20. (40% of $3 is $1.20.)

So the stock is essentially where it was when it started. But the option that was worth $500 is now off by -$30 or -6% from its original value when you bought it.

If that move happened over a course of weeks or more, the loss in the option would likely be even greater as the option would have experienced a larger amount of time decay.

Moreover, if the movement in the stock was slow and incremental over time, volatility would likely have decreased as well in the option, which means it would have reduced the delta even more, thus limiting your ability to 'make it back'.

And if your option is fully out-of-the money -- since your option has no intrinsic value but instead only time value, the less time you have left on your option, the less value that option will have.

Getting back to our example, let's say that option now has only a few weeks left until expiration and it's still out-of-the-money. That option could literally be worth only $20 or $30 (or less) – which is far from the $500 that you originally paid. And this is true even if the stock stayed the same or was even higher than when you bought the option.

And that's the point I want to make.

You cannot trade options solely based on the underlying stock.

If you buy a stock and it goes down, and then meanders about for a while before going back to where you bought it, your gain or loss is zero. You haven't made anything or lost anything. If you wanted to sell it for what you bought it for, you could.

With options though, you have to look at the option's delta, as well as the volatility (as this will impact the delta), and also how much time you have left on the option before it expires.

The option traders who consistently lose are the ones who forget about these simple things.

If you find yourself saying, "I might as well hang onto the option since it's fallen this far and since I still have time", you'll likely be the guy who turns a loss of some of his option premium into a loss of all of his option premium.

Now this article isn't meant to 'neg' anybody out on options. On the contrary, it's meant to empower someone to take decisive action and to cut their losses when the trade is not working out. Because while options provide great leverage with a small amount of money and a guaranteed limited risk – you do not have all the time in the world as you do with as stock.

If what you were expecting to see happen isn't happening, cut your losses and rethink your strategy before time runs out and you lose what you put in.

Nothing will 'neg-out' a new options trader quicker than losing his entire premium. And the way that happens is by not understanding an option's limitations in addition to its advantages.

So pay attention to the option's delta, time value/decay and volatility. And remember, when you're trading options, there's more to winning in options than just the underlying stock movement.

You can learn more about different 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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