Buying Options and Predicting Market Direction

Newer option traders tend to adopt the strategy of buying calls when they are bullish and puts when they are bearish.

It is very easy to buy some options based on your market savvy. In other words, you -- like the majority of new investors -- probably believe that the trade will be profitable because you believe that the stock price will behave as you predict.


That is based on the belief that you have a talent for stock picking and timing the market.

Despite a ton of data to the contrary (Numerous available data sources illustrate that individual investors perform far worse than the market averages when making buy/sell decisions) most still believe that they are not average investors and have the ability to beat the market.

It's somewhat amazing when you think about it. No one would expect to become a .300 hitter when first picking up a baseball bat; no one would expect to practice medicine immediately after graduating medical school (they become interns to continue their education); yet people believe that it is easy to beat the stock market with no special training and that they can easily match the performance of the most skilled professional option traders. 

 

Risk vs. Reward

Those beliefs often lead to unwise investment decisions. That brings up the topic: How much money can you afford to risk when making investment decisions based on your ability to know what the future holds?

The more difficult questions are:

• Can you estimate the probability of earning a profit from a given trade?
• How does the potential profit compare with the money at risk?

Example

The inexperienced option trader may look at a $40 stock, decide that the price is heading higher and seeing that the two-month option with a $45 strike price costs 'only' $0.15 (that's $15 per contract), decides to invest $75 by buying 5 contracts. 

Analysis of the trade
The risk is only $75, so at first glance this seems to be an acceptable trade. After all, the potential gain is theoretically unlimited and the maximum loss is just $75.

However, that is not the whole story. This is a stock whose price fluctuations are tiny. Translation: this is a non-volatile stock. In fact, over the past couple of years, the average daily price change is only 5-cents per share. The probability that the price can rally far enough in 45 trading days to turn this investment profitable is less than 1%. In other words, the likelihood of earning any profit from this trade is dismal and the most likely outcome is a 100% loss.

This is a bad trade with a poor risk/reward profile. If you truly believe that there is something in this company's future that will move the stock price higher -- despite its stodgy price-change history -- then you want to buy an in-the-money option. I suggest buying calls struck at $35 (i.e., $35 strike price), despite the fact that they cost just over $500 per option. The true risk of buying options on this stock is that the price is unlikely to change by much over the lifetime of the option. For that reason, you cannot afford to pay much time premium (the cost of the option above its intrinsic value) for options on this specific stock. The intrinsic value of the call struck at $35 is $500 so it would be reasonable to pay $5.10 or $5.20 for this option. 

Don't be concerned that the option costs $500. If this were a volatile stock, then there would be real risk if the stock market declined. But this is a stock of a solid company and the true risk for the option buyer comes with paying too much time premium for the option. When dealing with more volatile stocks -- stocks capable of significant price changes -- then everything is different because options on volatile stocks cost more (i.e., they have a higher time premium or volatility component).

Bottom line: It is true that risk is measured by total dollars that can be lost, but an trader must be aware of probabilities and be sure not to buy options which deliver almost no chance to earn a profit.