CHAPTER 3: BUYING OPTIONS OUTRIGHT ISN’T ALWAYS A GREAT “OPTION”
My first conversation with beginning traders is generally debunking the myth that option trading always entails limited risk and a lack of required margin. These assumptions are true when buying calls or puts outright, but traders who are employing spread strategies or are selling options naked are expected to post a good-faith deposit to cover potential losses known as margin. Also, these traders might or might not be exposed to unlimited risk; spread traders who have purchased an option of the same type for any short option held will have limited risk exposure, but any trader who sells an option without also being long an option of the same type, a practice known as buying coverage, will face unlimited risk. In extreme scenarios, the losses incurred by naked short options and short option spread trading can wrack up surprisingly fast. Yet, limited risk strategies such as outright option buying offer dismal odds of success. Specifically, low and limited risk trades executed in frequency can cause a trading account to slowly bleed cash.
DISADVANTAGES OF OPTION BUYING
The practice of buying calls and puts is generally referred to as long option trading. Long option strategies are exactly as the name implies. It may include the purchase of a single option or it may be the purchase of an option spread in the form of a strangle or a straddle. Technically, vertical spreads also fall into the category of long option strategies, but for now, we will focus on the purchase of calls and puts either outright or in the form of straddles and strangles (vertical spreads are discussed in detail in Chapter 5).
Long option strategies, by definition, entail limited risk and unlimited profit potential, causing beginning traders to flock to the strategy. It is nice to know that regardless how wrong the speculation is or how poor the timing, the maximum damage is the cost of the option being purchased. Even better, the premium paid for the call or put gives the trader the “option” to buy or sell the futures contract at the stated strike price, which creates the potential for unlimited profits; thus, an option buyer sleeps well at night. It is a comfortable strategy until you consider the bleak probability of success.
The bottom line is options are priced to lose. After all, there must be somebody willing to sell the option at a particular price before a trader can purchase it. The trader selling the option has expectedly done their homework regarding the likelihood of it paying out and has priced the option accordingly. Making the prospects of triumph for option buyers even worse, options are eroding assets.
This chapter will focus on the mechanics of option buying as well as the limitations. In my opinion, long option traders are generally forfeiting the probability of success for peace of mind. As a long option trader, the worst-case scenario for a trade is to lose all the money spent on the option. Sadly, the maximum loss can occur even if the predicted market direction is accurate. As you will soon be aware, limited risk isn’t necessarily synonymous with less risk. Despite the obvious benefit of limited risk, other factors work against the odds of success: primarily, time decay, the 80/20 rule, time limit, and market direction.
An option is an eroding asset; every minute that passes has a negative effect on its value. Many are under the assumption that if a trader buys a call option and the market goes up, he will make money. This cannot be farther from the truth. While it is possible for the value of a call option to go up in a rising market, it is also possible for a call option to lose value as the underlying asset ascends. In contrast, in extreme cases of exploding volatility, the price of a call option can increase despite a descending futures market.
Example: In late September 2019, March corn was trading at $3.70 and a trader could buy a January $4.10 call for $0.04, or $200 because each penny is worth $50 to the trader, with three months left. For the option to be profitable the market must climb enough to outpace time decay. If on the day of expiration, the market is trading at $4.05, even though the market has rallied 35 cents from the day of purchase the option will expire worthless to result in the maximum loss of $200 plus commission and fees for the buyer (Figure 12).
Figure 12: This chart depicts the price change in a January $4.10 call option in corn following a rally from $3.70 to $4.10.
Depressing, isn’t it? The trader’s speculation was correct, but the market didn’t go far enough in the allotted time frame to return a profit at expiration. At any time before expiration, it is possible the position would have been profitable, but that would depend on the extrinsic value. In early October, corn rallied to $4.10 (Figure 13). The move occurred almost immediately after the option was hypothetically purchased, rather than taking two months to get there. Accordingly, the trader would have experienced very little time value erosion but would have benefited from increases in extrinsic value due to the spike in volatility, increased demand for the option, and favorable futures market movement. Had the trader exercised keen timing, he could have sold the option for $0.13 or $650. This would have netted a profit of $0.09 ($450) before considering transaction costs. In other words, although the price of the underlying futures price must be beyond the strike price of the option to be profitable at expiration, at any time before expiration the option could be profitable despite the futures price not being beyond the strike price. We will later learn this simple concept is often the bane of existence to beginning option sellers.