If you consider yourself an investor or trader chances are you’re familiar with options. The chances are even higher, matter of fact, almost guaranteed that you have been solicited by some firm or website claiming to be the “Ultimate Options Trading Newsletter!” I can speak from personal experience that I come across these newsletters daily when logging into my gmail account.
The sad and unfortunate truth is buying options is for suckers. I wish there could be a better way to articulate it but there isn’t. Let’s break down why you shouldn’t ever buy options if you care about preserving your capital and making money.
What is an option?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying stock at a specific price on or before a certain date.
- If you buy a call, you have the right to buy the underlying stock at the strike price on or before the expiration date.
- If you buy a put, you have the right to sell the stock on or before expiration.
The idea behind an option doesn’t need to be over complicated. Let’s take a look at an analogy.
Example: Imagine the “Jones Family” finds a house that they would love to purchase. Unfortunately, they don’t have the money right now and won’t have the funds to buy it for another four months. But this isn’t a pair of Nikes we’re talking about, this is there dream house! They would absolutely hate for someone else to come and buy it while they are waiting for the funds to purchase there home. So the “Jones Family” talks to the current owner and negotiates a deal that gives them an option to buy the house in four months for a price of $250,000. Fantastic! Now nobody else can purchase their dream house and this gives them time to accumulate the necessary funds. The owner agrees, but for this option, he requires the Jones Family to pay him $4,000.
What is option premium?
When you buy an option, the price you pay is called the premium. The premium isn’t fixed and changes constantly, therefore the premium you pay today will likely be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. This is known as “The Market.”
Example: In our example above the owner agreed to give the “Jones Family” the option to purchase their dream house for $250,000. While the owner agreed, he required that they gave him a $4,000 no money back fee while he holds the property over the next four months. All parties agreed with the terms and you now officially have an options contract.
What is Time Decay?
The rate in which an option’s price (the premium) decreases in relation to the expiration date. Options are wasting assets which simply means their value decreases over time. This is due to the probability of the outcome becoming clearer to the market as the expiration date approaches.
Example: As 3 months go by the “Jones Family” talks to their realtor and learns the value of their dream house has barely increased, the market is now valuing the home at $251,000. A measly $1000 increase and it doesn’t look like it will increase much more in 30 days, in fact there is a better chance of the home appraising for less than $250,000 by that time frame. So they sit back and think to themselves “Geez, here we paid $4000 for this option contract but the price of the home only increased $1,000 and may even fall below the price we locked in. For all intents and purposes we are going to lose $3,000 or possibly our entire premium.”
Only one outcome is favorable…
The true value of an option is recognized the day of expiration. The value is determined by whether or not the option is “in the money” or “out of the money” at expiration. Basically this means:
- A call option is only profitable if the price of the underlying stock is above the strike price plus the option premium you paid for the option.
- A put option is only profitable if the price of the underlying stock is below the strike price in addition to the option premium you paid for the option.
Example: Four months is up!
- The “Jones Family” talks to their realtor and discovers the home is assessed at $252,000. This means that the true value of the option they purchased was $2,000. Therefore they unfortunately lost $2,000 in this deal that they cannot get back.
- Another possible outcome could have been the home was assessed at $245,000, therefore the value of their option would have been worthless as the home was less than the $250,000 purchase price they initially reserved the option to exercise.
- Let’s take this one step further, if their realtor had told them the assessed value of the home was $265,000 they would have made $11,000 from the deal. Remember they agreed to pay $250,000 for the home but now it is worth $15,000 more but they must subtract $4,000 they initially paid the seller for the options contract.
So from these 3 examples you can conclude the following:
- If the price of the house dropped in value; you lose money
- If the price of the house stayed about the same in value, you lose money
- If the price of the house increased substantially, you make money
That is a potential success rate of 1 out of 3, better known as a 33% chance. An awful metric in terms of investing! Remember the number one rule to investing is to never lose money!