Don’t be cheap

BEDFORD

It is an inbuilt instinct for people to hope. Cheap options, just like Tattslotto, feed into this delusion that you could be an overnight millionaire with no skill required. The slight probability of winning is overcome by the small amount of money required for a Lotto ticket, and this seems irresistible and worth the gamble.
In the options market, you will not get rich because of some lucky break. It will take hard work and discipline before those elusive profits find their way into your bank account.
Novice buyers of options are particularly attracted to “cheap” options, which ironically have little probability of appreciating. This helps explain why a vast majority of option buyers end up net losers in the market.
In terms of risk/reward and probability, buyers of low-priced options make a trade with a low probability of success, where the rewards are high and the risk is minimal.

Why are they cheap?
Traders often buy options that have nominal time to expiry, which means that their bought asset is depreciating like a time bomb. Most options expire worthless and are only ever traded once. People don’t like to be “wrong”. They would rather sweep their bad trade under the carpet, along with any remaining value that they could claim by closing out their position, than confess that the trade didn’t work. There is no room for this type of ego in trading.
Often, naive traders underestimate the strength of a move required to affect the price of the option. These unfortunate souls believe that, even though BHP may have increased by only 10 cents in a month, it could potentially jump $10 within three days (when their option expires). Magically, BHP should recognise the brilliance of the trader with the deal in play and co-operate!
The concept of delta and gamma becomes extremely important in this situation – but, rather than learn what these terms mean and how to use them, overly optimistic traders would rather just place their orders and take their chances.
Delta measures the sensitivity of an option price to changes in the share price. Gamma measures the curvature of delta, so it can act as a precursor indicator when to exit a position. For advanced option plays, these two “greeks” or “option sensitivities” can greatly assist your chances of extracting a substantial profit.
When you next see that amazing bargain option at two cents, ask yourself why it is that price. Maybe there is a reason that you haven’t explored. Perhaps you are about to buy an option that is actually worth that small amount, not an option that has been mistakenly under-priced by market dynamics.

Brokers
Brokers receiving commission based on the number of contracts you buy – rather than your overall exposure – may urge you to buy cheap options with a short time before expiry because they make more money. This way, they convert your trading capital to brokerage with lightning precision. Don’t rely on your broker to guide you in this arena. Stand on your own two feet and take responsibility for your future by educating yourself about options, and identifying trades with a higher probability of success.
There is much less risk on the part of the broker when dealing in bought positions in comparison to written positions. Written positions contain contingent liability. This requires careful monitoring by both the client and the broker to eventuate in a profitable trade.
Alternatively, your trading account can be loaded up with bought positions without the need for close monitoring. With bought options, the worst thing that can happen is that you will lose everything you placed into the trade -you can’t lose your house. This is much simpler for brokers to monitor, and has the side benefit of their not ending up behind bars for inaccurate suggestions that led to their client’s financial collapse.
Buying at or in the money options with two to four months to expiry will often seem like a more expensive trade, but it is much more likely to eventuate in a profitable trade.

Written positions
When I first started writing naked options on NAB, I reached a startling conclusion. I was presented with two choices. I could choose to write five close-to-the-money option contracts, where I would seemingly take on more risk as the share price could easily break through my strike price, or I could write 28 option contracts that were miles out of the money, yet receive the same amount of money overall. For a brief moment, I thought I was completely brilliant!
Can you see the problem with writing more contracts but receiving the same amount of money in total? If you can’t see the problem with this, stop writing options immediately! I have one word that you must learn about before you progress: EXPOSURE.
By writing many more cheap option contracts, it seems as if your trade has a higher probability of success. However, what happens if a huge announcement is made, or if the share price goes ballistic? Your exposure is completely blown out of the water! Rather than being liable for 5000 NAB, I would have become responsible for 28,000 NAB if the trade had backfired. Yikes!
When we begin our trading career, we are strong, brave and bulletproof. The market had better not cross us. Unfortunately, the trading world doesn’t work this way, and often the market will provide a proverbial kick to our soft underbelly to ensure that we don’t repeat our past errors of being too cocky.

louise_bedford Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of four best-selling books – The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. Register on her website to receive a free trading plan template and a 5-part e-course to get you trading like a machine.

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