Option Pitfalls

Five Pitfalls Stock Option Investors Make Over and Over Again
By Jim Nelson
July 16, 2008

One of the best ways to make money in the stock market is to not buy stocks at all. But instead, buy a stock’s derivative — or option. This way, you can actually control more shares of stock than you would normally be able to afford with limited downside, and virtually unlimited upside.

Many savvy investors do this all the time, instead of wasting time on regular shares of companies that at best, will only produce a tenth of what the company’s options will potentially bring investors. We’re talking about upwards of triple-digit gains when regular shares only bring in single-digit ones.

Unfortunately, many people feel that options are too risky or confusing. To a brand-new investor, that may seem to be the case. But, with the right kind of preparation and skill, option investing is just as easy as anything. You just need to be aware of some pitfalls that many investors fall victim to.

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Here are the top five pitfalls you need to avoid to be successful with options:

Pitfall #5: Leverage

The basic concept of options investing is the ability to control more shares of a company for less money. For instance, say you wanted to buy 100 shares of Company X at $10 per share. You could either buy the shares outright and spend $1,000 or buy one call option and spend $100. That would give you the option to buy 100 shares of the company at $10 per share anytime before the date the call option expires. This is called the power of leverage.

Now, if the share price goes higher than $10, you can take the option to buy 100 shares for only $10 each and sell at the higher price…not a bad gain on very little risked. But if the share price falls lower than $10 and doesn’t recover by the expiration date, you lose everything. It expires worthless and you are out of $100.

Pitfall #4: Acting on a Whim

Many first-time option buyers jump in without all the knowledge they need. You might hear that Company X is going to be launching a new product this quarter and you want to leverage that bit of information to make an even larger profit on the company’s shares. So you buy a call option.

Well, many times the new product will actually cost the company more money on startup fees and not breakeven until the following quarter. Most likely, that would decrease the share price and leave you out-of-the money. If you had just bought shares, you could sit on those until the company turns a profit, or wait until it does before buying call options.

Pitfall #3: Choosing the Wrong Option Series

If you don’t know what you’re doing, you might end up choosing the wrong option series on the right stock. For instance, if you think shares of Company X are going to go down in the next few months, you should buy a put option.

But sometimes, you are better off just buying “in-the-money” puts than “out-of-the-money” ones. It all depends on how cheap the actual options are, not the share price. Be sure to study all your choices before buying a random one.

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Pitfall #2: All in on One Trade

Another problem many options investors have is not diversifying their portfolios. Thirty percent of all options expire worthless. While that is a lot less than most people think, it’s still not perfect. All option gurus out there have a few that crash. But, don’t let one bad one ruin your investment portfolio.

While I would recommend a few safer plays — be it stocks, bonds, or even LEAP options — you should still carry a few options at one time to diversify that part of your portfolio. That way, you won’t get crushed when one turns sour.

Pitfall #1: When to Sell

This is not only a pitfall for options investors, this is true with all investments. But the reason this is particularly dangerous for options investors is because there are two parts to betting on options…price and time.

If you have an option go “in-the-money” and you are up a considerable amount of money, you might want to think about selling that option and cashing out. Take your profits. But the opposite is still true when you are coming close to expiration. It may be better to cut your losses on “out-of-the-money” plays when you are fast approaching expiring worthless. Even if you only get a tiny fraction of your investment, it’s better than being greedy up until the point of no return.

With these five common mistakes in mind, you can avoid the horror stories you are told about options. The truth is, when you are smart about your investments, especially options, you can make a killing in the stock market. But, always be aware of how you and others have made mistakes in the past.

Sincerely,
Jim Nelson

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