It’s A Dangerous World. Revisited

I believe this post from 7/8/2008 is worth repeating:

I stress the importance of getting a solid options education before you begin trading. But it’s not that easy. The world is filled with bad advice. Each of you must decide if the statements made by an author make sense. The following is a brief excerpt from a well-respected options professional trader, teacher and author.

you can play and risk very little. Options can cost as little as $5.00 to control 100 shares of stock. And when you buy options, the most you can lose is what you pay for the option, nothing more. Consequently, buying options is the best way to start trading options.” (italics inserted)

It’s true that not every ‘expert’ agrees with every other expert and there is often no single ‘best’ answer to an options trading question.  But the author I quoted states that buying options doesn’t have to cost much and therefore it’s the best way to start.

I find that statement to be ludicrous and don’t mind saying so. Just because it costs $5 doesn’t make it a reasonable option to buy. Just because you cannot lose more than $5 (plus commissions), that’s not a good reason to make the trade.

Why would any investor want to begin trading options with a high probability of losing money? Sure it’s nice to get some hands-on trading experience – and that’s a great way to learn. But, why begin trading by making a trade that has a very small chance of earning money? Why buy a call option, watch the stock move higher and not understand why the $5 option is still worth only $5. What would that teach an investor? Wouldn’t anyone prefer to begin an options-trading career by adopting a strategy that has a much better chance of earning a profit? I know I would.

This writer doesn’t tell his readers that when you buy an option for $5, there’s little chance of ever making money.  Why? One reason may be that there’s so little time remaining before the option expires that the chance of the stock making the required move is tiny. Another reason is that the option is so far out of the money that the stock is extremely unlikely to move far enough for the option owner to earn a profit. I’m not suggesting anyone sell such options (that’s even worse than buying them because there’s too little reward to take the chance that something unusual happens), but I would never recommend buying them.

This author goes on to say:

“Avoid entering spreads or option writing.”

Spreads are a method for reducing the risk of trading options and are resoundingly recommended by me. Of the six strategies I recommend for option traders (including rookies), four are spread positions and one is similar to a spread because it’s a hedged, risk-reducing strategy. And that one is the option writing that this author tells novices to avoid.

Let me be clear on this point: In my opinion, writing covered calls is a better strategy than 'buy and hold' for individual stocks and I strongly recommend it as a good method for learning how options work. But, there are better, safer strategies you can use – after you understand how options work. I suggest writing covered calls as your entry point into the options universe, but once you understand what you are doing, it’s best to move on to another of my six recommended strategies.

 This author then offers this advice:

“start by taking some very small positions”

 And I completely agree with that statement.

I sincerely hope you find my writings to be helpful, well-reasoned and that they help you earn lots of money – and at the same time, reduce the risk of investing in the stock market.

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You can follow my trades on Twitter: MarkWolfinger

3 Responses to It’s A Dangerous World. Revisited

  1. Jim Lindor 01/29/2009 at 9:15 AM #

    Mark,
    Yes, there is a lot of bad advice out there.
    I subscribe to your blog using RSS. Is there any way to get notified when there are new comments?
    You used to have a feature where you could subscribe to an RSS feed for each blog post’s comments. That was a nuisance to have to subscribe for each post but it was better than nothing.

  2. Mark Wolfinger 01/29/2009 at 9:24 AM #

    I tend to publish every morning (5 or 6 days per week) before 6AM Central Time.
    I’ve rearranged how I respond to comments. Previously, I could not reply directly to a comment. I could add a comment at the end of the comment list. This is much better and keeps the reply attached to the question. But that RSS feature was lost in the transition.
    To be honest, I don’t quite know how to arrange notification. But I’ll ask and let you know.

  3. dave appel 01/29/2009 at 10:03 PM #

    Completely agree with you here. Option sellers have a strong edge. While there is gama risk, being a depreciating asset gives the seller the upper hand. I started trading options by selling calls on stock and moved into ratios, spreads, and even naked writing . ( I no longer sell naked options). From time to time I will buy options but it is rare and only if I see a strong edge. I find the excerpt you quoted unfortunate. there is a prevailing myth that buying options is a quick way to fast profits and being a seller of options is risky. What people fail to look at is how much they can potentially lose on trades. I beleive rookies need to understand the dynamics of options and risk management before they can trade them successfully. That is what I appreciate so much about this great site and your book.