Trading LEAPS Options: A Good Idea for Option Rookies?

A reader wants to know:

“I'm thinking of trying options for
the first time and couldn't find a menu where I could buy LEAPS calls. Can
anyone tell me how to do this?’

***

Welcome to the options universe.  Trading options can be a very enjoyable
experience, but it’s less enjoyable when you lose money!  I’m not in the business of telling anyone how
to play options or the stock market, but, in an effort to prevent your losing money, I must butt in here to ask: 

·       
Why
are you buying call options?  Why LEAPS?

·       
Do
you have a trading plan, or do you intend to buy LEAPS now, and hold until they
expire?

Assuming
you are bullish, buying call options appears to be a reasonable idea.  But, because this is your very first options
trade, I’m asking:

  • Do you understand how options work? 

  • If you plan to hold for a long
    time, what do you anticipate will happen to the price of your LEAPS
    calls if the stock rises?  How about if it falls? 

  • Do you understand the reasoning that goes into choosing a
    strike price?  Or an expiration
    date? Or deciding how much to pay for the options?

  • Do you recognize that if you make poor
    strike price selections or pay too
    much for the option, that your chances of making money are significantly
    reduced?

Most
beginners buy call options that are out of the money (the strike price is
higher than the current stock price) expecting, or hoping that the stock price
is headed much higher.  Often they see their stocks
rise, but they still lose money.  They fail to
recognize that much more goes into the price of an option than merely the price
of the underlying stock.  I am not trying
to discourage you.  I truly hope you will
be successful, but it’s also important to know what to expect when trading
options.  I hope you have not succumbed
to the boasting of a newsletter writer when making trade decisions.  You will do better on your own – once you
understand how options work.

I’m sure
you know that the passage of time slowly erodes the value of options –
and yes, with LEAPS that erosion is initially slow.  This is not the appropriate place to discuss
how options are valued, but for your financial well-being, you must (ok, no one
is holding a gun to your head, but you should) understand how options are
valued and why market volatility plays a large role in determining that value.

Choosing
an expiration date (even deciding to buy LEAPS vs. other calls) and a strike
price are not things to be done randomly. 
All I am asking is: are you ready to begin using options?  Are LEAPS appropriate for you? 

Have you
considered any other strategies besides buying LEAPS calls?  Are you taking the advice of an advisor who
doesn’t know you, and who offers generalized advice for all his/her
followers?  That’s not a good idea.

One other
problem with buying options is that the rookie doesn’t know what to do
next.  Do you have a price target for
your stock?  In other words, are you
using technical analysis or any other method for predicting how high you expect
the stock to move?  If the stock does get
to your target price, what do you plan to do? 
Sell the calls?  Hold through
expiration, even though your price has been reached?  Have you any plans to limit losses and sell
the call, if and when losses reach a certain level?  The point of this paragraph is to ask:  Do you have a plan?  Do you have an exit strategy?  Options do not trade themselves and the owner
of a position must make decisions.  Most
of the time, experience helps guide the investor.  Rookies lack that experience and need a plan.  The plan doesn't have to be cast in stone – you can be flexible, buy too many people make buying decisions and they never know when to sell.  That's true for stocks as well as options. 

Here's something no has told you: when buying options, you will lose money more than half the time – unless
you are a very talented stock picker.  If no one has explained that it's very difficult to make money when buying options, please allow me to be the first.  You must correctly pick direction.  Your timing must be reasonable, although LEAPS give you more time, you pay cash for that extra time.  
You must also gauge the size of the move and pick a reasonable strike price. 
Because losses are so frequent, losses must be limited, and you must develop trading guidelines
that enable you to manage risk.

Options
can be traded profitably, but please don’t expect buying call options to be
the path to wealth.  Unless you are one of those who believe stock prices are so
low that we are in the midst of the buying opportunity of a generation, buying calls may not be the best strategy for you.

Do you have a good track record of knowing when stocks are headed higher or lower?  Have you been able to pick stock direction
successfully?  Have you made a lot of money trading stocks, or are you following the advice of a market guru, hoping that person knows what he/she is doing.  If you have no proven track record, buying options is
not going to turn you into a gifted stock picker. 
If your record is good, you can do very well – but please be careful when choosing which
options to buy.

I’ve
written The Rookie’s Guide to Options for investors just like you.  It describes how options work – in detail –
and teaches several different strategies as well as how to manage risk.  Buying options is not your only alternative.

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