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From the Trading Pits

Close Only Counts in Horseshoes, Hand Grenades, and Options Trading

By From the Trading PitsFOXBusiness

Options are seductive and what makes them so is the underlying belief that the various and sundry sentiments represented by all of these collective opinions (buyers vs. sellers) can be somehow quantified. The belief that by looking at the past behavior of an asset, one can calculate the precise likelihood the asset will reach a particular price by a particular date, and whether the option is a good or bad deal at that price. Actually, the process is similar to the way an insurance company analyzes actuarial statistics in order to determine what to charge an applicant for life insurance premiums except options do not behave in the way that physical phenomena such as mortality statistics do. Physical events, whether death rates or card games, are the predictable function of a limited and stable set of factors and tend to follow what mathematicians call a “normal distribution,” or bell curve. If you’ve ever traded for any length of time, you will agree that markets do not follow any normal distribution. Markets are not normal.

Time creates a cozy hedge around our lives and the lives of everything surrounding us. Life insurance policies have a time element, food in your refrigerator has an expiration date, and corporate bonds have a maturity date. Time is also conditional in that a decade, a year, a month, a day, an hour or even a minute could potentially be as pivotal or inconsequential to our personal scheme of things.

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Each business day, stock and commodity exchanges around the globe open in the morning and close in the afternoon. A single trading day is best illustrated by a product’s opening, its daily price change (variance) and the closing price. Within those trading days, millions of decisions are subsequently made and predicated on the opinion of time or investment horizon. The, “when do I expect my money back,” is tortuously tied to the perception of time. Yet, after three decades of pondering, I think we may have it all backwards. Time and timing have certainly played an integral role in shredding some of my best investment ideas to ribbons. However, variance has hurt far worse than I care to describe.

Options - an investment vehicle that, by its very nature, is rooted with both time and variance.

The options market has grown at a record pace over the past 25 years. Today, one can buy or sell daily, weekly, monthly, or quarterly options on practically every exchange-traded instrument ranging from equities, bonds, to commodities. Options can be employed to express your conviction of an asset with respect to its expected movement (or, non-movement) within a particular time horizon of your choosing. Options can be used to buy volatility or protect against it. There are options on news events, weather, implied volatility. Today, there are even hourly options – offering detailed risk management to the hedger and a fast, quick pace outcome to the speculator.

An option is a derivatives contract. A derivative is an instrument that ultimately derives its value from something else. Simply put, a derivative is something that’s value is based on another source. It’s a contract, or a provision of a contract, that gives the buyer the right, but not the obligation to perform a specified transaction with another party (the seller) according to specified terms.

It is crucial to recognize when buying calls or puts, the potential loss is limited to the amount paid for those calls or puts. When selling calls, the potential ultimate loss is the difference between the strike price you sold and infinity. When selling puts, the potential greatest loss is the difference between the strike price you sold and zero. Let’s just say the potential loss for selling options can be unlimited for all intents and purposes. When you buy an option, you are reducing your risk by transferring it to the seller of the option. When you sell an option, you are receiving the risk from the buyer of the option. A buyer of an option pays a premium to gain control, whereas the seller of an option receives a premium for assuming the risk of losing control.

Foundations of Purchasing a Call Option

Let’s first begin with the long call as the foundations can be seamlessly applied elsewhere. In its most basic form, buying a call is a strategy employed if you think an asset price will rise. It can also be viewed as an alternative to buying the asset. Buying a call offers both leverage and limited risk. It typically costs much less to buy a call option than it does to buy the underlying asset and, is generally considered less risky than a position in an asset as you are buying a contract providing you with the privilege to buy yet not the obligation.

However, with the purchase of a call option you must be confident that the asset price will rise adequately before the expiry date of the option. Options expire; underlying assets (generally) do not. You can "sit” patiently on an underlying asset and hope that eventually it will rise in price. You simply cannot do that with a call option. If the underlying asset doesn't rise enough by a certain date, the call option may expire worthless or with a lesser price than you originally paid. In short, it's not enough to be bullish on an asset in order to figure out which call to buy.

With options, there may be significant tradeoffs between potential risk, the probability of profit, and the possible reward. Generally speaking, the lower the risk or the greater the profit probability, the smaller the potential percentage profit. No matter what you have read or been taught, it is highly unlikely that, in a course of a trading career, there will be giant potential percentage profits that are all but guaranteed to occur with little or no risk.

An options trader must always balance the tradeoff of risk (i.e. the amount of premium paid), the likelihood of profit, and the possible reward. For example, an options value is constantly eroding with time. As an options buyer, you are perpetually battling the decay of your option as time marches on while hoping for an advantageous move in the underlying or, a spike in the options implied volatility which will push the premium of the option back up. Hopefully, you can see the complication of both timing and the magnitude of the rise in the underlying asset price. There is nothing worse with options than being right with your conviction but wrong with your timing. Long options require both. Remember, you never get anything for free.

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