Message to Rookies (and Everyone Else): Avoid Overpaying for Options

Today’s Daily Options Report by Adam Warner  replied to a reader’s question. It concerns a topic that is extremely important to rookies, but sadly, more experienced traders need constant reminders about avoiding a costly trap. 

“Why are puts down with the stock down?”

When you buy or sell options
it’s a mistake to assume the price quoted is always a good, fair, and reasonable price. Many times there is a
special situation that makes these options attractive to own. (For example, when news is imminent. That news may be
an earnings announcement, trial results for a new drug, or an FDA announcement regarding a specific product.)

Why would the options be so attractive? Because the news can produce a significant change in the price of the underlying stock. If the news is good the price may soar. Investors who anticipate that possibility want to own call options prior to the news release. Similarly, bad news
can cause the stock to plummet. Investors who believe that may happen want to own put options prior to
the news release.

Thus, there are always
investors eager to own options when news is pending. That increased demand results in higher and
higher prices for the options. Even if the stock trades in a very narrow range, prices of both puts and calls tend to
increase when eager buyers are willing to pay whatever sellers ask them to pay. Investors who fail to understand this process enter the market, buy their options and think they have a good chance to make
some money.

Alas, it’s not that simple.  Once the news is released, whether the stock
moves higher or lower, there is no longer a demand for the options. In fact, everyone who bought before the news
now wants to sell. As you may imagine,
when supply exceeds demand, prices fall.

That brings us back to the
original question: Unless the stock
makes a major move to the downside, the price of put options can easily
decrease, even when the stock declines.

For specific details on how
this works, take a look at an article (link no longer active) I wrote for SFO in March 2005. The title is “Don’t Pay Too Much For Those Options: The Diary of a Premium Seller.” Overpaying for options is a trap you must avoid if you intend to profit by trading options.


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